Bold claim, I know, but hear me out. Markets (defined here as companies that people can invest in) have existed for several hundred years. The Dutch East India Company was the first company to ever be listed on an official stock exchange back in the 17th century. If you allow your mind to drift back to middle school history class, perhaps you can recall a few formative world events occurring between then and now, some good, some bad, some apocalyptically terrible. Here are a few: American Revolution, French Revolution, American Civil War, invention of the telephone, WWI, Great Depression, WW2, Cold War, etc. World power shifted between nations, wars ended countries and began new ones, and the only thing more predictable than another war was another famine (interestingly, there was a permanent global food shortage from the dawn of time until WW2). However, one thing you may not have heard in your middle school history class is that through all of the raging of nations, markets continued to provide a return, decade after decade. Market data, as primitive as it may have been in the 17th and 18th centuries confirms what we’ve seen from more comprehensive data in the 20th century, that markets consistently offer a significant return over time from company dividends (which were more popular back in previous centuries) and from company growth. As we well know, the market doesn’t go up every day or every year, we see the hills as well as the valleys, but history has demonstrated without exception that down markets are temporary and market growth is inevitable. It’s easy to fall prey to the idea that this time really is different, and it’s true that there are different things happening today than there were in the 1700s, but a prediction that the market won’t perform in the future is a bet against history.
What is it about the market that ‘works’? I mean, how do companies keep creating and innovating so consistently over time? How is it that you can invest money in your 20s and receive six times your investment when you retire in your 60s? How is it that people create value?
I’ll submit that the consistency and value of the market (of companies) and of people is directly tied to failure. You see, progress is made through trial and error. If there were no mistakes there would be nothing to learn from. The simple fact that companies and products sometimes fail is what drives innovation forward. It’s why entrepreneurs, regardless of their level of intelligence, are able to create immense value, they’re iterating on failure after failure. It’s why free markets have prevailed for centuries, failure is built into the mechanism. It’s why, on a personal level, the way that failure occurs to you will play an oversized role in your personal success. Winston Churchill famously said, “Success is the ability to go from one failure to another with no loss of enthusiasm.” But it’s even better than that, failures are the milestones on the way to success, they’re what makes success possible. So next time you fail, don’t dress it up, don’t make up reasons or excuses, squeeze every bit of valuable information you can out of it. It may have actually been a huge success.
We live in a fiat currency world. ‘Fiat’ simply means government-backed. The paper that dollars are written on is pretty close to worthless, but the U.S. government guarantees its value and other countries do the same for their own fiat currencies. The U.S. dollar is worth something, more than most other fiat currencies, because it’s backed by the most powerful government in the world. There are a few implications of this:
- In the past, humanity has utilized a multitude of different items or elements or commodities as money, ranging from cattle to gold, beads to shells, and anything in between. Very few of history’s currency still exist as anything resembling money for one main reason, they could be produced. The most important characteristic of money, or of anything valuable, is its rarity, the difficulty (or preferably the impossibility) of creating more of it. In order for money to hold value, it can’t be producible, there must be a limited supply. If it’s producible, there’s a massive incentive for people to produce it, and when people produce more of something, that thing loses value. This has happened countless times throughout history. Some Native American tribes used Wampum beads (gleaned from shells and clams) as money and used them to trade with European settlers. European settlers, with superior technology, were able to mass-produce the beads causing a massive devaluation. Wampum beads were inflated (or devalued, they mean the same thing) to the point that they became worthless, leaving the Native American tribes using them destitute. A similar issue is presented when we try to use commodities as money (silver, coffee, copper, etc.). Commodities are valuable (many us would be lost without our morning coffee and we’d have a hard time building skyscrapers without steel), but when demand for a commodity increases, so does the production of that commodity, so its value decreases. Money doesn’t need to have intrinsic value, it doesn’t have to be useful for anything else, it simply needs to be able to reasonably hold value through scarcity.
- Since we use fiat currency, the government controls the dollar and consequently has the ability to produce more of it. When they do, inflation happens. The government likes inflation. Since the U.S. officially and fully entered the fiat currency game in 1971, the U.S. dollar has been inflated (devalued) by around 3.86% per year, on average. The government introduces more money into the economy through various convoluted debt instruments and stimulus packages, decreasing the value of existing dollars. The belief is that a certain amount of inflation is good for an economy because it promotes spending and borrowing, the opposites of saving. It’s definitely not helpful for saving. If you left $100k in your savings account in an average year, at 3.86% inflation you would lose almost $4k. If the money is in a savings account, maybe the bank would offer you a tiny bit of interest to offset some of the loss. If you’re lucky you might get 1%, but you would still lose $3k. In one year! Leave your money alone in a bank account or under your mattress for any amount of time and you’re out a significant portion of your savings.
So the question remains, how do we save money?
Thankfully, there’s an answer. The solution to the devaluation of our dollars is investing. Specifically, investing in companies through the stock market. All that talk about long-term investing, diversification, portfolios, the stock market, etc., that stuff all has merit. The best way to overcome inflation in our day and age is to invest money in companies, and let it grow. The stock market is the great hedge against inflation. Market returns, over time, always outpace inflation. It doesn’t happen every year, when the market is down it can definitely be worse than inflation, but if you give it time, the market will always win, and by a large margin.
Unfortunately, as things are presently constituted, saving money is not incentivized. Fiat money and inflation encourage borrowing and spending. But, saving is more important now than ever (who’s in line for a pension when they retire?), and the stock market offers an incredible store of value, one that increases exponentially over time. Don’t skimp on your investments.
The market has been rocked. In the last two weeks (March 3-16, 2020), the S&P 500 has lost over 22% of its value. It’s the fastest 20% descent we’ve ever seen, and no one knows exactly where the bottom will be (or if we’ve already hit it). The market has moved in percentage multiples, both up and down, every day last week, an incredible level of volatility. The leading cause, which still feels surreal, is the propagating Covid-19 virus which has led to mass closings and increasing restrictions. Suffice it to say, it’s been a crazy couple of weeks.
In many ways, we’re in uncharted territory, which means we’ve got questions, like how are we supposed to respond to all of this? What’s the right thing to do when we’re confused about what’s happening? To add some clarity, I’ll offer up a few investing principles throughout this week.
Market timing doesn’t work.
- No one knows what the market will do tomorrow. Many make predictions, but no one really knows. Don’t try to guess where the bottom is, or when we’ll hit it, or when to pull money out of the market, or when to put the money back in. The market is efficient.
- Let’s say you really want to get out of the market because you don’t believe we’ve hit the bottom yet and you’re not interested in sticking around to find out. In order to successfully time the market you have to get two bets right: you have to get out of the market before it hits the bottom, and you have to get back in at or very near the bottom. The odds are not favorable.
- A market study conducted at the University of Michigan measured returns from 1963 through 2004 (a period of 42 years). They found that 96% of the positive returns over that period came from 0.85% of trading days (90 out of 10,573 total trading days).
- Another study done by A. Stotz Investment Research observed a 10 year period, from November 2005 through October 2015. After running the data through several simulations, they concluded that if you missed the 10 best market days over the specified 10 year period, you would stand to lose, on average, 66% of the gains you would have captured by staying in the market.
- When the market moves up, it moves up quickly. Whenever your money is on the sidelines, you risk missing some of the best days the market has to offer. So stay invested, don’t panic, and anticipate the rebound.
As I write this on March 9, 2020, market indexes across the board are down, some by as much as 9%. Coronavirus has made the market skittish enough over the last few weeks, to compound things Saudi Arabia announced massive cuts to the price of oil this morning, which actually seems kind of great (lower gas prices!), but markets have not reacted kindly. The response feels like panic. It’s certainly a bad day in the market, but I want to provide a little bit of context for all of this.
Here’s what you should know:
- Unless you know the future or have inside information (unlikely, and illegal to trade on), you should be a long term investor. Short term market moves are pure gambles, and most often end up hurting investors. Don’t move money based on fear, which is all we hear in the news, especially on days like today.
- Despite what pundits may be saying, no one knows what the market will do tomorrow. No one knows where the bottom of a downturn is, no one knows how long it will last or how quickly the market will come back. Don’t panic with your money, especially when the market is down.
- Bad market days have happened before. On Black Monday (October 19, 1987) the Dow Jones Industrial Average dropped 22.61%, in one day! In order to crack the top 20 bad market days the Dow would have to lose 7%, but even if that does happen, we’ve seen the market bounce back from far worse.
- The market bounces back quickly. When the S&P 500 loses 10% or more it recoups all losses within an average of about 4 months. The worst thing you can do is move money when the market is down and miss the bounce-back.
- A limited number of great days in the market account for most of the great returns. A 20 year period between 1998 and 2018 included 5,040 trading days. If you missed the 30 best market days out of the total 5,040, you would have ended up with a slightly negative return over the 20 year period, $10,000 would have turned into less than $9,000. We don’t know when those great days will come (though we know they often follow bad days) but we definitely don’t want to miss them by being out of the market.
- Markets move, but the general trajectory is up. If you’re invested for the long haul and you understand your risk tolerance, bad market days are no problem. They don’t even have to be stressful.
Here’s what you should do (or not do):
- Don’t panic. This is not the first time we’ve had a bad day in the market and it won’t be the last. The worst thing you can do is move your money out of the market. In fact, bad days in the market are a great time to invest more.
- Make sure you understand how and why you’re invested the way you are. The market will sustain losses, but an un-diversified portfolio stands to lose a lot more. On the flip side, a well-diversified portfolio can put your mind at ease.
- Make sure your diversified portfolio has a systematic way of rebalancing. When the market is moving, a system for rebalancing will ensure that parts of the portfolio that are doing well are sold, and the parts that are down are bought. It’s an automatic ‘buy-high-sell-low’ feature.
- Work with an investor coach. When things look bad, all the news and information surrounding you will only confirm your worst fears. An investor coach will keep you disciplined, make sure the accounts are rebalanced, and will ultimately guide you through turbulent markets to a successful outcome.