Why a stock market crash is actually good for you

This article is not another “Pray for a crash because you can buy the dip” kind of article. That you know already. And how can you buy the dip if you’re already invested in the markets anyway.

This blog post is about showing why even when you have no money to buy the dip, a stock market crash during your wealth accumulation phase is actually a blessing.

With the S&P 500 down -16% from 2018’s peak and the global markets in much worse shape, it makes sense to be skeptical. We’re losing money and that may only the beginning. Or it can be just a wound. Time will tell. But should we really worry?

I examine three different investment journeys and how they play out depending on how the market performs. The contributions at each journey are exactly the same. An investor starts with a fixed amount (say £40,000) and invests £10,000 at the beginning of each year. The market return in 10-years time is exactly the same across all journeys. 100%.

In other words, if each investor put £50,000 to work, made NO extra contributions and looked at it 10 years later, they would have doubled their money: £100,000. Or an average return of 7.2% per year.

To clarify: If they don’t make any extra contributions along the way, the three investors will end up with the same exact amount. Double the money.

Here comes the critical part. If they, however, invest a fixed amount each year in addition to their initial lump sum, the end result is completely different across the 3 journeys. And I don’t mean a bit different, I mean remarkably different.

Despite the fact that the average returns are very similar, it’s the sequence that these returns occur that makes a huge difference to your wallet.

Scenario 1: Brilliant start, bitter end

The beginning that every investor wishes for. Our investor, Alice, took some solid financial advice and started investing her £50,000 as soon as possible. This happened to be at the end of the recession where stock prices are dead cheap.

As a result, Alice enjoyed a great start and doubled her money in just 5 years! Here are the actual market returns.

Not so bad, 7 out of 10 years she made a positive return. As with every scenario, Alice topped up her investments every January 1st. £10,000 year after year.

Alice only experienced one really bad year (-20%) but four great ones. Her investments rocketed more than 20% in 4 different years.

Scenario 2: Steady as you go

What a boring investment journey! Bob expected that markets will return 7.2% on average these 10 years and got exactly that.

He actually tried to spice up his journey by adding all sort of investments, stock picks, peer-to-peer and even TSLA! But on average he got a 7.2% year in year out.

Same as Alice, Bob invested £50,000 in the beginning and £10,000 every year thereafter. He proudly talked about his investments at dinner parties every year, since he always made money in the capital markets.

Scenario 3: Double Whammy

Here our unlucky investor, Charlie, watches from the sidelines as other people make money in the stock market. Year after year Charlie is thinking of investing but he’s afraid of losing money.

Finally, in the 10th year of the bull market, he decides he doesn’t want to miss out anymore. He reads Foxy Monkey and finds out that if he doesn’t invest, inflation will erode his money anyway. So he takes the plunge!

Only to find out that the first two years are painful as hell. At the end of the first year, his £50,000 drop to £35,000. A -30% in the red! The 2nd year is no better. He loses another 15%.

He takes one punch after the other. Year after year Charlie is pouring £10,000 into the stock market, as promised. Meanwhile, the neighbour keeps reminding him “I told you to stay away from the stock market”. He stops reading Foxy Monkey as Michael is probably a big fool.

But Buffet says “The stock market is a device for transferring money from the impatient to the patient”. So he keeps investing at the beginning of each year as intended.

In fact, in the first 5 years, he barely sees a profit. Only by the end of the 6th year, he starts making a profit. His investment journey finally sees some light and makes some positive returns thanks to how capitalism works.

The economy has been slowly improving as it has always done, but now the people stop being fearful and start being greedy. They show some optimism again after 5 years of mediocre returns. Let’s see how our investors performed.

Showtime

So overall, our three investors had put exactly an initial £50,000. In all 3 scenarios, our investors doubled their initial £50,000.

But they also decided to contribute the same amount (£10,000) each year for 10 years. So each of them put a total of £140,000 out of their pockets. Let’s see their final amount at the end of the 10th year:

• Alice (Scenario 1 – brilliant start): £193,262
• Bob (Scenario 2 – steady): £229,330
• Charlie (Scenario 3 – double whammy): £300,711

Whoah! As you can see, although the annualised market return in 10 years was exactly the same (7.2%) across scenarios, their individual results are vastly different! Charlie made a staggering £106,000 more than Alice.

Why is that? Simply because investors had contributed at different market levels despite having contributed the same exact amounts each year. Charlie is clearly the winner here. That’s because he contributed mostly when the market was down, allowing for his new money to compound much faster.

Alice, on the other hand, had similar good and bad years but her contributions only bought her fewer shares each time since she was mostly buying when the market was expensive.

As counter-intuitive as it may sound, bad returns are good for your future money.

It’s not only the returns that matter when we invest. It’s the sequence of returns that matters too. Having a 30% drop at the end of your investment journey is a big “OUCH”.

This is one of the reasons early retirees fear a big market drop at the beginning of their retirement. They work one more year to make sure they can cover potential losses in the beginning. Others change their allocation to a more defensive 60/40 stock-bond portfolio to protect themselves from big drops in the first few years.

Having a 30% drop during my contribution years though? It’s a blessing! I can now buy the same companies 30% cheaper.

When I go to the supermarket and see the oranges half-price I don’t regret having bought last week’s batch at a higher price.
I better buy now as many as I can That’s because I know oranges are great and will always get more expensive as time goes by.

Perhaps it will be better if people saw the stock market as if they’re buying the “Greatest businesses of this world”. The ones that made it big and managed to go public. The Nestles, the Apples and the Amazons that keep innovating. Buying the human productivity and make a long-term bet on it. That’s how I see the stock market.

The market follows the economy, productivity and output of each nation. But it doesn’t always work like a clock. Short-term is mostly psychology. The market may go up in a day simply because there are more buyers than sellers. Similarly, the market may go down because everyone wants to sell out of fear.

But eventually, it gravitates towards the fundamentals. Earning’s growth, GDP, unemployment rate. The world’s economy is improving, things are slowly getting better which is why the long-term number is always positive.

For those of us that still contribute to the stock market, bad returns are a blessing. In fact, when the market goes up, yes, we may make more money right now, as Alice does, but all I know is that our future expected returns are now lower.

To emphasise, the ideal scenario for me (but not for my psychological well-being…) would be to contribute to an ever dropping market and when I hit the number I want, let the market climb up again.

Saving vs Investing

Contributing to a falling market is so hard though. Topping up your investments in the red feels like touching a hot stove just after you burned yourself. But sadly, it’s the most rewarding.

The most common behaviour is to wait until the dust settles and only start contributing when the market is at previous levels. That’s of course very inefficient from a math point of view, as we miss out on huge returns on the comeback.

Alice, Bob and Charlie all saved hard. Saving hard is important but investing during bad times is critical as well. We should embrace volatility and make it our friend. Volatility is what makes an asset class give a higher return in exchange for a bumpier ride. We’d easily pick Bob’s 7.2% a year but what we should vote for is Charlie’s market returns while we accumulate wealth.

Conclusion

Investing in market downturns is easier said than done. Nobody said it’s easy. But this is where money is made and what separates professional investors from amateurs. Funny thing that investing is more of a psychological game rather than a financial one. Isn’t it.

Same as Alice, I’m proud when my investments are going well. But in fact, Charlie’s poor years are the best when I am at this stage of my life that I can contribute the most.

Sometimes I like property investing better than stocks because it feels like a more stable journey. But is stable the best possible route?

Now knowing all these, how would you describe your ideal investment journey?