Let's face it - the market has been doing great lately. We've seen virtually everything go up during the last ten months or so, ever since the election. Talk of tax cuts should add further fuel to the fire, since less money being diverted out of the economy means more money for investment and spending.
But eventually, this party will come to an end. Indeed, many economists and pundits have been talking about the frothy nature of the market and saying that maybe it is time to move towards the exits. I would say that this is good advice for some, but not for everybody. It is good advice if you need the money within a year or two, or maybe even a few years, but it is not good advice if you don't need the money for twenty years.
You see, markets that have plenty of people trading, which the stock markets do, will instantly price in all news, expectations, and insights. If people knew that the markets were about to decline, they would be selling now, which means that prices would be going lower already. The fact that there are plenty of people willing to come forward and buy shares at current prices says that people have seen all of the news out there and decided that current prices are reasonable. Sure, bad news may come out tomorrow and cause stock prices to fall, but the market might continue to climb for another year or two. If you're sitting there on the sidelines with a pile of cash, you'll be losing money to inflation, missing out on dividends, and perhaps missing out on a 20-40% gain in share prices before the fall happens.
So why should people who need the money in a few years sell? The reason is that when big drops do occur, it typically requires 2-5 years for the markets to recover back to where they were before the drop. The average amount of time required, looking at all periods since 1926, is 3.3 years. That means if a big drop happened today, it might take 3, four, or even 5 years before share prices returned to where they were before the crash. In really bad times, like the Great Depression, it might take 10-15 years. If you really need the money within 5-10 years, and the consequences of not having all of the money would be dire, sell. If you could get by with half and you have 5-10 years, it might make sense to hold on.
If you really need the money within 5-10 years, and the consequences of not having all of the money would be dire, sell. If you could get by with half and you have 5-10 years, it might make sense to hold on. If you need the money next year, your chances are about 60/40 that your account will be higher by then.
So what should you do if the market crashes and you don't need the money for a long time?
1. Don't panic. As the Hitchhiker's Guide to the galaxy says, don't panic. Panicky people do stupid things, like selling in the middle of a decline. The best thing you can do during a market decline is to just relax and stick to your investment plan.
2. Do nothing. A market crash is a bit like skidding on the ice. The best thing you can do is to take your feet off the peddles and let yourself coast to a stop. I usually just stop following stocks for a while, maybe checking account balances about once a month or two, and maybe looking for some stocks on which to take a loss as a tax deduction if it is around the end of the year. Otherwise, I just wait for a recovery.
3. Buy more. Instead of looking at a market crash as a bad thing, when you're many years out from needing the money, it can actually be a great thing to see prices decline. Typically stocks go down well below their fair value when everybody's selling, so a market crash is a great opportunity to load up on cheap shares. Some of the best returns you'll ever see come the year or two after a major market decline. If you can raise some money to allow you to scoop up some shares, basically everything will be on sale. Realize, however, that there may be a few downturns before the market finally straightens out and head up again, so don't be discouraged if your shares decline after you make your first purchase or two. You'll probably not buy at the bottom.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
