Here’s a claim you might have never expected me to make. I can predict the next stock market crash with 100% accuracy.
Well, let me clarify. I can predict that there will be a crash. But I don’t know when. Or how bad it will be.
Beyond being able to confidently declare that the market will slide, I have no special clairvoyance or insight. My predictive powers basically amount to guessing.
So have I bailed and moved all my money to a safe haven? Nope. My investments are still comprised of 100% stocks.
Let’s talk about why I’m so confident a stock market slide is coming, why I can’t predict when, why I’m still invested in all stocks, why I won’t always be, and how you can think about managing risk.
The Slide is Coming
One easy way to know that the stock market is going to crash is the simple observation that it has crashed before.
It’s true that past results don’t predict future performance, but they give you a good general idea of what you’re dealing with.
For instance, I live in Florida. The fact that we’ve experienced hurricanes in the past doesn’t mean we will in the future. But it’s pretty clear that if you live in the sunshine state, you should consider hurricanes a real risk.
In the same way, volatility is just part of the risk of owning stocks. The market goes up and it goes down. But most it goes up. In Florida, you get sunshine and hurricanes. But you mostly get sunshine.
Why Does the Market Do This?
The basic answer is that humans (as a group) can be sort of crazy.
Remember, the stock market is a secondary market. You don’t buy shares of a company from the company itself; you buy them from someone selling their shares. Some buyers are long-term investors and some are trying to make a quick buck. Some sellers are retirees and some are trying to cut their losses.
When things are going good, people pile into the stock market. Some of them even borrow money to do this, which drives up prices further.
Eventually something happens in the economy or in the market of buying and selling stocks that spooks everyone.
And that’s where things can get crazy. Everyone rushes to get out and prices go into a free fall.
Can You Predict When it Will Happen (Or How Bad it Will Be?)
You might think you can, but you can’t. You can guess, which feels a lot like predicting something when you get it right, but the two aren’t the same.
Very clever people with very sophisticated math can’t even figure out what the market will do. Why is it so hard?
You Can’t Predict the Future
Let’s think about one of the ways that people try to predict if the market is due for a crash or correction.
There is a ratio called the P/E Ratio that compares the share price of a company to their earnings per share. So if a company has a $10 stock price and made $2 in earnings for every outstanding share, it would have a P/E Ratio of 5.
You can do the same thing for the stock market as a whole. If you do, you’ll discover that the average P/E Ratio of the stock market is something like 15. So this sounds simple, if the P/E Ratio is much higher than 15, you’re due for a crash or correction. You’re talking the subjective part (the price) and comparing it against an objective measure (earnings).
It all sounds very logical and neat doesn’t it?
- Maybe the higher price to earnings reflects an (accurate) prediction by investors that companies experience higher growth than normal in the future
- Even if this metric tells us we’re do for a correction, there’s no telling when it will happen
Both of these problems are just different ways of saying the same thing: you can’t predict the future.
You Aren’t Just Predicting One Thing
Even if you could in some small part predict the future, knowing a crash is coming isn’t enough. You need to know when, how bad it will be, and when the market will recover in order for your knowledge to do you any good.
As an example, I’m writing this in May of 2021. We’ve been experiencing a raging bull market that has lasted since the 2008 financial crisis.
For years I’ve been seeing people say that you should get out of the stock market. The price is too high. The market is too hot. Yada yada yada.
Well, I have news for you. If you’ve been sitting on the sidelines waiting for a market crash since 2015, you’ve missed out on some unreal gains. I guess we had a “crash” in March 2020. We’ll call that the Covid Crash.
Here’s what that looked like:
It looked like the pandemic had wiped out over three years worth of gains, but things turned around quickly. Even if you predicted the drop and sold at the 2/19/2020 high of 3,386, I hope you got back in quickly. It turns out that 11/3/2020 was the last day that you could buy back in for less than the previous record high of 3,386.
It may be that another crash comes and knocks us down that low, but no one knows for sure. In order to time the market, you have to be right twice (at least). You have to guess the top and the bottom.
Protecting Yourself From Stock Market Slides
The best way to protect yourself from the volatility of the stock market is to diversify. If you’re invested in a total stock market index fund, you’re already diversified in terms of companies and industries, but not asset classes.
In other words, it doesn’t matter much if individual companies or industries do poorly, but it does matter if stocks as a whole don’t do well.
By diversifying into another asset class, you protect part of your portfolio from the markets’ volatility. You also set up the ability to buy stocks at a discount when you rebalance.
To illustrate, let’s say you own 10,000 shares of an imaginary stock market index fund, priced at $100 each. That’s a cool million-dollar portfolio. Let’s see what happens if the market takes a 30% dip:
Let’s pretend that instead of going all-in on stocks, you put half your money in bonds. Our imaginary bond index fund also starts at $100 a share, but it appreciates by 5%:
In the all-stock portfolio you lost a full 30%, but in the stock/bond portfolio half your money was shielded from the crash. Here’s what happens after you rebalance:
In order to rebalance, you sell some bonds and use the money to buy stocks. You end up with the same $875,000 in your portfolio at the end, but you now have more shares of your stock index fund than you did before.
You’ve basically forced yourself into buy low/sell high transaction. With more shares of stock than before, you’ll be better positioned to take advantage of any subsequent growth.
Why I’m Invested in All Stocks
So if asset allocation is such a powerful strategy, why am I not using it?
First of all, I will be using it in the future. I’m just not in a hurry to get there. I have two things on my side that help protect me from market volatility without diversifying across asset classes.
The longer your money will be invested, the more time you have to bounce back from a crash.
As I’ve pointed out in a previous post, with enough time in the market you can weather multiple stock market crashes and end up a huge winner in the long run.
Since I’m only 34 and I’ll probably be investing for a while before I make any withdrawals, time is on my side.
Another thing that smooths the ride is making regular contributions. Losing $10,000 to a market crash has a negligible effect on your portfolio if you go on to put in another $10,000 that year.
Not only am I making regular contributions, but as my income increases, the size of my contributions is increasing.
Market Crashes as an Opportunity
If you’re like me and you plan on having money in the market for the rest of your life, market crashes are a great way to make more money in the stock market.
You don’t need to do anything different, just keep following your normal investment plan.
Think of it like this: If the market went up in a straight line, there would be less risk, but each dollar you invested would grow less than the one before it. The money that I invest in 2030 would be able to buy fewer shared than the money I invested in 2020.
But if the market crashes, all of a sudden shares of my index fund are on sale. In the example above, instead of needing to fork over $100 for a share, each one only costs $70.
As it stands right now, the money I’ve yet to invest is likely far greater than the money I’ve already invested. So I would welcome a crash, even one with a slow recovery. If we have an extended bear market followed by a raging bull, I’ll make out like a bandit. I’ll be buying tons of shares on sale and experience huge returns once I’ve built up some capital.
Here are the important things to remember:
- The next big stock market slide or crash is coming
- No one knows when it will be or how long it will last
- Diversifying asset classes is a great way to protect yourself
- With a long enough time horizon, you might be able to weather the storm
- Regular contributions help smooth the ride
- Market crashes early in your investing career can be a good thing
You can’t predict the future, but you can set yourself up for success with sound investing habits.