Should You Be Afraid of a Stock Market Crash?

Bear Markets

US stocks have been on a tear over the past 6 years, with the S&P 500 index of large US stocks returning over 200% since its nadir in March 2009. Such a lengthy bull market can lead to concern about when it will inevitably end; after all, stock markets tend not to rise forever. But if such fear leads you to hoard cash rather than invest it, you’re likely making a mistake, particularly if you have a long time horizon for your portfolio.

To see why such fear is mistaken, let’s take an example where you invested $1,000 in the S&P 500 index at the start of each calendar year. Even in an extreme situation where your timing was abysmal and you began making these investments near the starts of the worst stock market downturns in history, after suffering some sizable early losses you’d still be in positive territory within a few years.

The worst of these downturns was during the Great Depression. Even if you began in 1929—the beginning of an epically nasty bear market where US stocks lost 2/3 of their value of from the start of 1929 through the end of 1932—you’d have more money than you put in within 7 years. In less prolonged slumps the recovery would take far less time: if you started in 2008, you’d be back in the black by the end of 2009.

These results suggest that for investors with a long time horizon, the downside of even a worst-case scenario isn’t that dire. Having a more diversified portfolio containing other asset classes in addition to US stocks could reduce risk even more.

By contrast, there’s plenty of peril in holding too much cash. The “what goes up must eventually come down” logic can be applied at almost any point during any bull market, so using it will almost certainly cause you to miss extended periods when markets perform well. In fact, stock markets reaching new highs are generally a sign of a protracted bull market rather than an imminent collapse. Unless you’re able to time the market with far more precision than financial professionals can, keeping your money in cash rather than investing it is likely to result in a smaller portfolio over time.

How to Think Like a Long-Term Investor

Road

For investors concerned about what will affect the long-term growth of their portfolio, it can be difficult to focus on the right issues. Most financial news stories are produced for traders and others in the financial industry who are interested in daily market movements. After all, their paychecks can depend on what goes up and what goes down. But for long-term investors, the implications of what’s happening can be very different. Here are a few interesting—and perhaps counter-intuitive—ideas for long-term investors to keep in mind amid the din of financial markets:

1) Low valuations can be good. It’s nice to have a bigger portfolio, so it feels good when the values of your investments go up. But if you’re building up your nest egg, you actually want prices to be cheap so your money goes farther. You’ll end up getting the best outcome if valuations are low during the “accumulation phase” of your life when you’re buying investments and high during the “spending” phase of your life when you’re selling investments.

2) Volatility isn’t necessarily bad. The up and down movements of financial markets can be gut-wrenching. But if you’re making periodic investments over time, such as putting a portion of each paycheck into a retirement account, there can sometimes be a bright side to volatility. Since your money buys more shares when the market is lower than when the market is higher, the ups and downs may result in a larger portfolio over time than if the market had been flat. This phenomenon is similar to the idea behind dollar-cost averaging.

3) Standard deviation may be the wrong measure of risk. The riskiness of investments (or even entire portfolios) is often described using “annualized standard deviations,” which are statistical measures that can be used to estimate the range of possible outcomes for a 1-year period. But even assuming that these estimates are accurate, using them to estimate potential outcomes over longer periods of time typically means assuming that what happens in one year doesn’t affect what happens in subsequent years. In the real world this assumption isn’t true, so these kinds of estimates may overstate or understate how much risk you’re actually taking.

What the Job Boom Means for Stocks

Jobs Stocks

On Friday the Bureau of Labor Statistics announced that the economy added 257,000 jobs in January and increased its estimate of last year’s job gains. The 3.1 million jobs that were added in 2014 according to the latest numbers were the most since the turn of the century, and 2015 seems to be off to a strong start as well. So what does this job market boom mean for your portfolio? The answer, perhaps surprisingly, is “probably not much.”

We’ve noted in the past that there’s only a weak relationship between the strength of the economy and how well the stock market performs. This can be seen in the graph above, which shows the relationship between how many jobs the US economy has gained or lost each year (on the x-axis, shown in millions) and the annual returns of US stocks (on the y-axis) over the past 10 years.

The black line shows that there has been a positive relationship between job growth and stock market performance, but it’s not a very strong one. (For the statistically-minded, the job growth explains less than 10% of the variation in stock market performance during this period).

There are clearly some years where the job market and the stock market moved in the same direction: 2008 had massive job losses and a tanking stock market, while 2013 had job gains and a stock market surge. But there are also years where there’s seemingly no relationship. In 2009 the economy shed almost 5 million jobs while US stocks rose by almost 30%. The stock market was flat in 2011, when there were almost as many job gains as in 2013.

This weak relationship doesn’t mean that the job market is completely meaningless when it comes to your portfolio. It could have less direct effects on a number of investments by affecting when the Federal Reserve starts to raise interest rates and whether the US dollar continues to gain in value against foreign currencies. But by itself the fact that the US economy looks likely to have another year of strong job growth doesn’t reveal much about how the stock market will perform.