When Stocks Drop, The Biggest Threat is the Person You Face In The Mirror

Jean Melek feels queasy.  The 50-year old school teacher’s investments have dropped almost 8 percent over the past 30 days.  Plenty of forecasters say stocks will fall further.  “We’ve been getting frequent newsletter emails from Charles Schwab,” she says.  “They’re telling us not to panic.  But for us, those emails are having the opposite effect.”

Jean’s brokerage has the right idea.  But it’s tough to harness stock market panic. News media networks love reporting bad news.  If they can find someone calling for financial Armageddon, they happily amplify that voice.  The recent market crash is no exception.  And it’s especially tough on investors like Jean.  She and her 48-year old husband have never experienced a stock market crash.  They first started to invest in 2009.  U.S. stocks have risen every year since then.

U.S. stocks rose in 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016 and 2017.  That was an all-time record calendar-year streak.  As I wrote in April, such consistent gains aren’t normal.  Instead, stock market drops are normal.

Between 1926 and 2017, the S&P 500 averaged a compound annual return of 9.77 percent.  That’s why investors expect annual returns between 8 to 10 percent. But since 1926, the S&P 500 has never recorded a calendar year return within that range.  Not once.  Each individual year, the S&P 500 has recorded calendar year results below 8 percent or above 10 percent.  On average, U.S. stocks fall 1 out of every 3 years. If we adjust our investment behavior based on stock market forecasts, we usually pay a hefty price.

Plenty of people fear stock market drops, especially new investors.  When stocks fall, many people sell.  Plenty of others cease to add fresh money.  They stop contributing to their investments.  They choose to wait until things return to normal.  But this is as crazy as eating sand for breakfast– because market drops are normal.

The chart below shows mutual fund redemption levels between 1986 and 2015. Redemptions occur when people lose faith in their funds and they sell.  Notice the mutual fund redemptions in 1987.  Many people sold, mid-year, as the stock market crashed.  But such investors missed out.  U.S. stocks recovered quickly, actually earning a profit in 1987.  The investors that sold sealed in their losses.

Notice the increasing number of investors that sold their mutual funds between 2001 and 2002.  During that time, stocks were on sale.  The S&P 500 had dropped almost 37 percent between January 2001 and October 30, 2002.  But investors who sold during those 20 months paid a hefty price.  Many sold low, only to buy back later after the market had climbed. From October 30, 2002 until October 30, 2006, the S&P 500 gained a total of 68 percent. 

Notice the high redemptions in 2008 and early 2009.  U.S. stocks dropped about 37 percent in 2008.  That should have been a signal to buy even more.  But as seen on the chart, too many investors sold.  Many of those same investors re-entered the market, after it had risen.

Investing is simple.  Build a diversified portfolio of low-cost index funds.  It should include exposure to U.S. stocks, international stocks and bonds. If you’re working, add money every month.  Rebalance the portfolio once a year to keep a consistent allocation.  Don’t pay attention to market forecasts.  Tune out stock market news.  It might be best, in fact, to never look at your portfolio’s balance.

This sounds simple.  But most people mess it up.  Here’s an example.  Between 2003 and 2013, U.S. stock market funds averaged a compound annual return of 7.3 percent.  That would have turned a $10,000 investment into $20,230.  But according to Morningstar, the average investor in U.S. stock market funds averaged a compound annual return of just 4.8 percent over the same time period.  That would have turned a $10,000 investment into $15,981. 

This is a really big deal.  Instead of earning a $10,230 profit, the average investor earned a profit of just $5,981 on a $10,000 investment.  In only ten years the simple investor has left the average investor in the dust, opening a gap that will compound year after year.

Many investors didn’t perform well because they let greed and fear make their decisions.  They listened to market forecasts.  They didn’t stay the course. When stocks fell hard, many investors sold or they ceased to add fresh money. Stock market journalists, as they often do, added acid to investors’ stomachs with their end-of-the world headlines.

I’ve been giving investment seminars for about 15 years.  Sometimes, I meet the same investors many years later.  They often show me their portfolios.  But most of the time, their performance lags the results of the funds they own. I’ve also noticed a difference between men and women. Men are more likely to violate investment rules.  They speculate more.  Men are more likely to ask about Bitcoin.  They listen more to the media and their ever-churning guts.  Men try to time the market more.  But such timing doesn’t work.  Plenty of studies confirm what I’ve observed.

If you’ll be earning an income over the next five years, celebrate market drops.  If you’re young, smile even broader when the market falls.  If you retire on the cusp of a market drop, maintain your cool.  Stay calm, diversify and follow investment rules.  If you do, you shouldn’t run out of money.

Stock market drops might cause your gut to ache.  But they’re normal.  The bigger enemy, unfortunately, might be the person in the mirror. 

Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas

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