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Today’s guest post, “Key Money Mistake: Fearing Price Declines” comes from Value Indexer. VI writes about enjoying wealth in all its forms at Simply Rich Life, and about index fund ideas and research at Value Indexer. |
I’ve noticed an odd trend while reading some personal finance blogs lately. People have been making a serious money mistake while saying it’s wonderful. I used to make the same mistake too, but I’ve corrected it over time. Yet this money mistake can do more harm than buying a new car or even an overpriced Vancouver house.
What is this threat that’s eating away at peoples’ financial security? If you’ve calculated your investment returns for the last year (if not, it’s easy to do) you’ve probably made the same error yet again. The big money mistake I’m referring to is feeling good when the value of your investment portfolio goes up. When you’re young, falling markets are good news. Seriously. But when you check your portfolio balance and it’s gone up, what is your first reaction? It’s glee. Judging by the writing on most blogs and readers’ comments, most people are still getting it wrong.
You Just Might Get What You Need
The ideal scenario is for stock markets (and your portfolio value) to fall until the day you retire so you can (1) continuously buy cheaply, (2) enjoy excellent long term dividends and, (3) have better odds of enjoying capital growth post-retirement. Of course, we can’t always get what we want from the markets nor can we hope to time them. Nevertheless, (I may be wrong about demographics, but) I don’t think the majority of bloggers and commenters are in their 60s and living off of their investments. If you’re not in that age range and you do expect to hold your portfolio for a long time, the only thing to hope for is falling prices.
Falling prices make us nervous. It’s psychologically painful, and looks like the start of a negative trend. But the stock market — as a whole — will never go to 0. Falling prices are only a temporary trend which makes them a gift to anyone who isn’t planning to sell in the next decade. Sadly, that gift is all too rare since major stock markets only have an annual loss during about 1 in 3 years. Falling bond prices are even less common, but those are good for you too — assuming you’re liquid and not indebted — because it happens when interest rates go up. Higher interest, higher yield.
Rising prices in your portfolio will drag down your performance sometime in the future. Think about it: assuming you’re smart enough to re-balance your portfolio you’ll probably need to sell assets, realize capital gains (then pay taxes if it’s not a TFSA or RRSP), make new investments, etc.
Meanwhile, In 2033…
To see how today’s price is meaningless, let’s imagine a young person (let’s name her Adina). She’s saving aggressively and plans to retire in 20 years. We can’t accurately predict what the world will be like in 20 years. We can, however, guess that the economy will have grown, most of today’s companies will have increased their profits, a few corporations will have failed, and new companies will have risen from the ashes to offer unexpected products and services. If Adina holds one unit of a broad and reliable stock market index — let’s say the S&P 500 — it will have a certain price on December 31st, 2033. (Editor Joe’s Note: that’s a Saturday.) We don’t know exactly what that price will be. We can hypothesize, however, that the price will be higher.
Meanwhile us old-timers back in 2013 are facing a different environment. We can predict that, this year, people will continue to freak out over fake political dramas and media-exaggerated disasters. If the next grand game of chicken (are we now onto the 2013 Debt Ceiling debate?) ends in the worst case scenario — a head-on crash with no deal — we could have an economic catastrophe. Markets could plummet this year. Maybe Congress will kick the can down the road again. The markets could fluctuate heavily but stagnate overall (much to the delight of brokers who make their money on trading volume not direction). Heck, perhaps the meme of an American Renaissance per Garth Turner’s predictions will take hold and the S&P will be up triple digits. My point is we can’t predict what the price of one S&P 500 unit will one year from today.
But what does that have to do with its price in 2033? By that time Obama and Boehner will be listed in modern history books (er, eBooks) next to Cicero, Marcus Aurelius, and Stepehn Harper’s sweater-vests (jokes, nobody cares about Canada). Most of today’s news will have no impact on market prices and investment returns in the distant future, with one exception. News can cause prices to fall in 2013. If Adina buys at news-induced low prices today and then holds on until 2033, she will have earned a significant return. Buying at temporarily low prices creates permanent profits.
It’s The End Of The World And I Feel Fine
So we all agree that if markets fall for the next few years that’s good for us. But what if it really hits the fan? What if the crackpots are right and the most reliable predictor of the S&P 500 known to man — butter production in Bangladesh — is actually calling for a multi-decade crash in the market? What if we’re about to make Japan’s long term return look good and your portfolio doesn’t recover before you retire? You got it: that’s A.O.K, too!
If all stock prices fell by 70% while companies kept making the same profits, you could enjoy massive, sustainable dividend yields from the major indices. If the prices never recovered you could re-invest those dividends at an ever-more insane rate of return, which would compound gains better than price growth (especially if they’re eligible for the dividend tax credit). Over several decades, the high yields would make up for the initial loss and give you a much larger portfolio than you would have owned without a crash. Plus it’d probably be spinning off cash better. As long as the economy is still going (this is an assumption but a safe one; otherwise your savings will just be paper to burn), a multi-decade price crash isn’t just manageable. It’s one of the best things that could happen for a DIY investor. If you react properly. Sadly, such silly predictions are deemed silly because they’re, well, silly. Bad news has a shelf life. Low prices are generally temporary, especially because smart people like Warren Buffett react with brilliant greed and restore Mr. Market’s equilibrium.
Overcome Your Instincts
If you won’t be withdrawing from your portfolio in the next 5 to 10 years, bad news is good news. Every year that your portfolio value drops is a bonus when you aren’t close to retirement, so long as you manage your reactions properly This requires discipline, self-control, and emotional stability, which most people lack. We enjoy short-term rewards even if they are a money mistake because the desire for instant gratification is burned into our brains by evolution. Training yourself to have the right reactions and to make the right decisions will increase your long-term investment returns. You can profit long-term from the money mistakes of others made in the short-term.
One way to train yourself to avoid this money mistake is to read the financial news and then reverse the sentiment as dramatically as you can — practice being a contrarian. If the media reports a good week for stocks, recognize that it’s a terrible ordeal. If the media reports that investors are nervous, celebrate a great buying opportunity. If prices rise after you buy, you were unlucky. If those sentences seem counter-intuitive, good. That’s the point. Maybe your intuition is great when you’re playing Dr. Mom, but when it comes to financial markets your intuition sucks.
Another way to train your emotions is to give yourself a penalty. Every time you react the wrong way you can send me $50 and eventually you will learn not to do it. Actually, you don’t even need to write a cheque. If you act, or fail to act, because of baser instincts rather than rational analysis, you are already sending me money.
I still react the wrong way for a few seconds after checking my portfolio. But when it comes time to make decisions I have fully internalized the agonizing pain of rising prices and the joy of falling prices. With more experience the right reaction will come sooner. Unfortunately our portfolio return was 9.4% last year — but, with a little help from the media, we’ll hopefully have a loss in 2013 so I can invest at cheaper prices.
I’m grateful to all those who contribute to my portfolio by making the money mistake of reacting poorly. But you’re free to join me any time.
You seem to be saying “buy low and sell high”. This doesn’t make any sense at all.
Kidding. Except, not really. Why isn’t everyone freaking on equities right now and buying every bit of them they can buy? Because we’re waiting for prices to go up before we buy.
Holla’!
Great post! I need to remind myself of this every so often.
Agree with Glenn. Such a simple but forgotten idea; the entire media system is setup to crush this concept so no wonder it gets lost.
You only lose me at one point: “What if we’re about to make Japan’s long term return look good and your portfolio doesn’t recover before you retire?” I do want my portfolio to be high the day I return. I’d love to ride a bull market into retirement because I’d annuitize a good chunk of cash at high rates at a younger age.
A bull market can be a potent source of returns, but a high yield is under-appreciated! Ok, maybe not these days, but there isn’t much sustainable yield available. If that reversed itself we could do well.
I’ve owned Automodular for like 4 months and I’ve already made like a 20% return LOL. Yield and risk are positively correlated, but even if a person has a low tolerance they should at least look at a well-diversified junk bond fund for registered investments (not withstanding the coming rise in yields that will suppress prices) and preferred shares for non-registered.
Better watch out, Automodular might be the next yield-chaser target with its special dividends! All the predictions that retirees will drain the market may turn out to be backwards since they currently seem to be buying up anything with a dividend. If this continues we will be wishing for a market crash.
David Swensen had an interesting analysis in one of his books where he pointed out that (at the time) junk bonds and corporate bonds weren’t attractive because the spread over safer bonds was too small. I just looked up a random high-yield ETF and it’s got 6.5% over the last year (in the US). I’m not sure if that’s higher or lower than the average spread though. I might look at adding something like that as a small percentage of the portfolio for a few years to get a better understanding.
While hoarding cash in a company’s vaults might seem brilliant because of the tax efficiency for investors and increased growth potential, here’s my issues: markets decline, competitors enter, companies stagnate, and, worst of all, companies often allocate capital ineffectively (especially when they have too much lying around; CEOs can have silly pet projects, too). Without yield, you’ll never get your money out of many companies. Just look at RIM. They could have been paying out a few bucks a year and compensating investors up until they really needed to “circle the wagons” and fix their internal problems. They’d be in the same position, but investors would have looked more favourably upon them even after the dividend cut. But now, their entire company history is as a company that has literally burned cash. As much as I think Jim Balsillie was one of the greatest CEOs, a dividend is an accountability measure. Is it perfectly tax efficient? No. Is it way more tax efficient (assuming it’s an eligible dividend or it’s a US stock held in an RRSP) than capital gains? ABSOLUTELY.
While that is an interesting macro concern re: yield-chasing, I will posit that a panacea on an individual stock level is to do a proper analysis of the stock including the almighty Payout Ratio.
I like yields – that’s one of the two reason falling prices are good. There’s enough incompetent management that a lot of companies could cut out half the “investments” they’re making and increase their long-term returns as a result. That’s also a major reason that measures like price-to-book are misleading, because book value can be burnt down quickly. So overall I like to get a steady yield mixed with some re-investment (plus I just reinvest the cash that I do get).
I just found it ironic that everyone predicting that boomers will crash the market by pulling back didn’t expect them to double down in pursuit of yield while ignoring the risk. A world with too much excess capital seeking income could raise prices and crush yields for a long time to come. If they come after Automodular you can always sell it at a nice quick gain and find something else
If I get driven out of stock indexes I’m not sure what a good alternative would be since bonds don’t seem likely to be a lot more attractive in that environment.
That’s actually a pretty good argument for believing stock market indexes will rise in the next decade (which could easily make them overpriced). I’m sure management would respond by shifting towards more dividends as the excitement over capital gains wears off.
Good topic.
Related—Suze Orman is a HUGE proponent of dollar cost averaging–which is distinctly different than investing a % of your money every time you get a paycheque (a very sound financial habit).
What she supports is that if you had a chunk of money, say from an inheritance on January 1st, she’d have you invest it over the year in bits, rather than stick the whole thing in an index fund on Jan 1.
But rationally, if we expect that the markets will increase over time (and if we don’t why would we invest in them at all?) then it makes sense to take all the money you have available for investing and putting it in the markets today, because later they will be higher. Simple logic.
What Suze supports is akin to timing the market, and investing that money as it goes down and back up again over the year. I guess in extremely volatile markets, you could try to time your purchases on the down 2% days. But to me, you’d be better off just investing it on day one and set it/forget it.
That’s like playing a carnival game where the target keeps moving. We don’t know what’s high or low, or even what’s a bit gain or loss for that matter except in the extremes. If the market just goes straight up this year, or if the biggest loss is 1.9% instead of 2%, you can miss out on a lot.
It’s really an asset allocation decision. I wouldn’t put 50% of my portfolio in cash at the start of every year. If I had enough to want to avoid short-term losses, I might increase the bond allocation. That’s an unrealistic scenario for me because I will try to avoid depending on the portfolio so much that I can’t ride out a nice downturn to get a bigger 10-year return.
Multiple studies, to which I am too lazy at the moment to look up and link, have found that 60-70% of the time, you are better off having invested a lumpsum all at once, rather than spread it out. Spreading, rather than investing in a lump, likely offers some psychological benefit so you might feel better, but data shows that more often than not it yields a poorer result. At the end, I agree with VI – get your asset allocation right, and get in.
I try to be a contrarian investor but at times emotions get in the way. With this early 2013 bull market Logic should be telling us to take money out and protect our gains. IMHO we shouldn’t be buying into it but protecting the gains. I made the classic herd mentality mistake in early 2012 of NOT protecting my gains and rode the market down after that. My portfolio had a slow and painful recovery period and now it’s well above it’s recovery point. But you can make one sure bet and that is that I won’t repeat last years mistake!
That sounds like a good view Jose! I’m a long-term investor so I don’t move things around too much as long as I’m comfortable with the likely returns over the next 10-20 years. With rising prices now I would like to look at gradually shifting the balance but bonds haven’t fallen enough yet to be attractive (the last few days have been a start). Let’s hope for a bond market crash followed by a stock market crash the next year!