Rational brain, you must be out of your — my — mind! Even after the recent rally, my portfolio is still a smoking crater, my firm is laying people off, and you are telling me to invest in equities? I am digging a hole and putting my money there. I DO NOT trust you, my financial advisor, Jim Cramer, or even Warren Buffett anymore.
Sure, that’s your choice. But if you stop investing now, you’re likely to be much worse off down the road. Not investing is a choice with its own costs. Realize that you’ll lose out to the person who keeps his head and invests whether the markets are up or down. Freeze in the headlights — or worse, bail out and sit on the sidelines ― and it will take you much, much longer to get back where you started.
But what if the recent rally was a head fake and we’re headed for another long leg down?
Let’s set aside that apocalyptic vision for the moment and just talk about the math. With the market down 44 percent you would need your remaining investments to rise by more than three-fourths just to get you back to even. But if you invest when the markets are down, you’ll lower your average cost and rebound faster. If you wait until a stock market recovery has clearly taken hold (as if it’s ever clear except in retrospect), you’ll miss the big jump that happens once the market bottoms out.
Right. I’ve heard that one before.
Let me illustrate how the numbers work. There are these two guys Charlie and Max. Charlie takes the plunge and invests $10,000 in a stock index fund at the top of the market. (It’s always dangerous to drop a large lump sum into the market on one day; better to stagger it.) In less than a year, the market drops 50 percent and his money evaporates to just $5,000. Charlie does not want to buy more. He does not want to book his losses. He is as frozen as a hare on a highway.
Then there is Max, who’s read a lot of Benjamin Graham and Warren Buffett and Peter Lynch and believes that while the stock market rises and falls on emotion, it ultimately returns to the intrinsic value of the companies underlying each individual stock. He invests $10,000 on the same day as Charlie. Then a year later with the market down 50 percent, he reflects on the odds that the true value of corporate America has in reality been cut in half, concludes that’s unlikely, and invests another $5,000. It pains him to throw good money after bad, but he pulls out his copy of Graham and reaffirms the faith.
Thereafter, the market recovers 10 percent a year. Now see how our characters’ experiences differ. At the end of year two, Charlie’s investment has shrunk to $5,500. He doesn’t recoup his investment until year 10, which he ends with $10,717. (Of course, taking inflation into account, he is still under water.) Max, who invested a total of $15,000, is down to $11,000 by the end of year two. But by the end of year six, he’s up to $16,105, recouping his investment four years faster than Charlie.
So, by continuing to invest through the downturn you not only get your money back faster, you begin to make money faster too. The point is this: If you just stand there, you will plod back to your high point. But if you bring down your average cost, you will bounce back faster.
All that assumes that stocks will rise from here. True, you don’t know for sure that they will. Look at the mess the economy is in.
Look, investing is really about your view of the future. So, if you genuinely think that the U.S. as a nation will be unable to bounce back, sure, bury your money in the back yard. It’s conceivable that the past is not a good guide to the future of the U.S., and that it’s all over for American-style capitalism. But how likely is that really? The same panicky predictions were made in the 1930s and, to a lesser extent, in the 1970s. But if you believe in the essential resilience of free enterprise, you’d have to conclude that, while there is no certainty, history and human nature favor a rebound.
Yeah. Yeah. But why do I have to start this now? What if the recent rally was just a dead cat bounce, and we’re headed for a lost decade, like Japan’s? Their market still hasn’t recovered. What if this is as bad as the Great Depression?
Good question. Let’s take Charlie and Max back in time, using real numbers, to the worst bear market ever, the 1930s.
It’s December of 1928 and both buy $1,000 worth of the Standard & Poor’s 500 index, and then invest $100 each month thereafter. Max is the rational investor, the sort who would read Graham (if Graham had been writing in 1928) and who religiously puts $100 each month into the S&P 500. Charlie, on the other hand, is given to alternating bouts of despair and euphoria about the markets, and his heart sinks when the market crashes in 1929. In an effort to save what little he has left, he puts his monthly $100 into T-bills.
Now fast forward to the summer of 1932. The markets have fallen a heart-stopping 80 percent. Over the four years ending June 30, Max is down a total 67 percent. Charlie is looking brilliant with a 6 percent gain. Still, Max continues to put in his $100 each month into the S&P 500, while Charlie keeps investing in T-bills. By the summer of 1935, the world looks very different, and so do their portfolios. Max is up 13 percent, versus Charlie’s 4 percent.
But time magnifies the differences. Ten years later, Max is up 43 percent, while Charlie continues to plod along with a 3 percent gain. By January 2009, Max is up a mind-blowing 30,890 percent, while Charlie manages to puff out a total return of 844 percent. That amounts to an average annual gain of 4.47 percent for Charlie, 10.11 percent for Max.
The morale of this tale: If you want to recoup your losses, playing it safe in Treasuries or other cash investments is a painfully slow path to your goal. The math suggests that you have to take some risk. Adding money to stocks now will bring down the average cost of your holdings and spring-load your portfolio for when the market recovers for real, whenever that is.
Granted, it’s plenty hard psychologically to listen to the rational half of your brain, when everything about the current situation is screaming at you to take cover. No one knows when the real rebound will come, and, yes, you could lose more before you gain. But the math is pretty clear: when a lasting upswing comes, you will want to be in the market.
