I recently saw a question posted on Facebook about investing. The gist was: people recommend putting money into the stock market and letting it ride for the long term, but what happens if you invest (specifically in an index fund) and then there’s such a big crash that you lose all of the money because you hadn’t invested much?
For readers that are experienced investors this may just seem like a beginner’s misunderstanding, (which, sure, it is) but it also underlines a very common problem that even experienced investors have in how they think about their portfolio. So, let’s talk about both!
Let me start by saying that if you’re buying individual stocks, especially something speculative like penny stocks, the scenario in the question is certainly possible. A company’s share value can be completely wiped out and you can lose everything. Same thing goes for the super-hot-right-now crypto-currencies. Also, If you’re -brave-foolish enough to trade on margin (using debt as leverage to buy more shares than you have money to pay for), a share price doesn’t even necessarily have to hit zero to wipe you out, there just needs to be more margin calls than you can afford.
This is just one of many reasons why I always favor investing in a broad-based index fund of the entire economy, such as VTSAX. In this case, you’re buying a portion of the entire US economy, rather than a portion of a single company. Most people will agree that the odds of the entire country ceasing to function and produce economic value are pretty small and if that happens, we’ll all probably have bigger problems than where we invested our money…
So, back to the question- if you’re investing in an index fund and we have a big, stock market crash like we did in 2008 or 2001, it is going to be rough. No doubt about that. Seeing the value of your investment drop by half or more is incredibly painful and scary. However, the two main points here are that:
1) Your value isn’t going to drop to zero
The world may have seemed like it was coming to an end during those crashes (especially if you regularly watch the news like I always advise against), but in reality the US economy continue to produce goods and services and the value of our index funds, while diminished, was still positive. In fact, during the worst of the great recession (2009), the unemployment rate peaked at about 10%, meaning 90% of the country’s workers were still out there earning money for investors like you and me. Even if you invested directly before the crash, you would not have lost everything. Okay, that doesn’t sound reassuring but it leads me to…
2) You only lose if you sell
This is the thing that even experienced, highly intelligent investors fall victim to because the psychology and the fear are so strong. When we see a huge crash, it’s only natural to worry that things might not bounce back and to want to sell while you can, before it gets worse. The thing is, you don’t actually lose money when the market crashes. You lose money when the market crashes AND you sell your investments at the low price. It takes a lot of mental strength, but we need to be training ourselves to look at crashes as opportunities (“Shares I want to buy are on sale! I’ll get as many as I can!”) rather than worrying that the end is nigh. The best first step is to pay as little attention to share prices and the news as possible.
Trading vs Investing
Everyone knows the common adage, “Buy Low, Sell High”, but the implication there is that you should be watching the prices regularly and trading frequently to capitalize on these price changes. That’s fine if you’re a day trader by profession, but what I advise instead is a Buy-and-Hold strategy. It’s pretty simple: you earn money, you use it to buy shares of the market index, and then you don’t sell it. Sure, one day you’ll sell it, a couple decades from now when you don’t have a job and you’re using your sizable nest egg to pay for your retirement, but that’s not going to be a concern any time soon and therefore the price of shares and what’s happening in the market should not be your concern.
Warren Buffett has a great analogy for the stock market and value investing, where he talks about owning a farm where every day a neighbor comes by and yells out a price he’d pay for the farm, or how much he’d want for his. Each day the prices change, sometimes wildly, but every day it should just be ignored. He/you bought the farm because it has an economic value and will turn a profit, not to flip it for a quick buck. This is the approach you should take with investing in the market. Instead, if we belabor this analogy, if every day you’re listening to your neighbor as he tells you the value of your farm is plummeting and you better sell it while you can, you’re causing yourself a lot of stress and are likely to lose a bunch of money when the panic convinces you to sell.
So take the Warren Buffett approach of buying a business (or EVERY business with an Index fund) because it has value; that’s investing. Don’t get caught up in what the market thinks a share price should cost on any given day; that’s trading. Investing will gradually grow your nest egg until you find yourself wealthy. Trading will trick you into buying things that are overpriced and selling during a panic. It’s an easy choice.
During market climbs and market crashes there are always hundreds of voices telling you what you should do with your dollars in the market and it can get pretty scary. Sometimes the fear can lead you to stay out of the market and miss out on gains and sometimes the fear can lead you to pull out of the market and lock in your losses. If you can tune out this noise and focus on fundamentals (like consistently investing over the course of years and diversifying your risks with index funds), you’ll come out ahead.
That all sounds well and good, but I’ve been there when the world felt like it was falling apart in 2008 and 2009 and it’s hard to stay optimistic. One trick I like to use during these times is to remember that you’re buying shares, not storing dollars. Let’s say I had 10,000 shares of VTSAX that I acquired over the course of many years. Today they’d be worth over $600,000. If tomorrow the market crashed and the share price plummeted to $30 per share. Suddenly my account would say $300,000 which sounds depressing. Fortunately, I’m not selling today, or any time soon and what’s that? I still have 100,000 shares which represent ownership of hundreds of businesses in a US economy that is almost certainly going to rebound and grow into the future. By focusing on the shares and not the dollars, a crash is a whole lot easier to weather.
I’ve recommended it before, but that’s because it’s fantastic: Check out Jim Collins’ excellent Stock Series. He’s also got a great book out that covers the same topics in a nice, clear manner. Jim covers all things I think about investing, but in a way that’s way more intelligible and educational than I could ever manage.
- Invest consistently in a broad-based index fund and don’t plan to sell until you’re retired and this will be your income.
- Ignore the talking heads and the daily share price changes, even scary situations like market crashes, they don’t matter to your investing.
- Focus on acquiring shares, not on the dollar value of an account. The prior will steadily grow and lead you to wealth, the latter will fluctuate wildly in the short term and just cause you stress and encourage bad behavior (like panicked selling).