Are you afraid of losing money in your investment portfolio during the next market downturn? You’re not alone. Our human brains are wired to worry more about losing money than gaining an equivalent value due to something psychologists call loss aversion. Perhaps this is why so many people talk about different strategies you should employ in your investment portfolio before the next market downturn. This feeds our desire to protect what we have now.
I’ll admit that when I started investing years ago, I had this same tendency. I would look at my portfolio daily to check and see if things had gone down. I would scan the latest headlines looking for signs of an impending market crash. Of course, if you look hard enough finding these types of articles isn’t that hard.
The problem with investing history is we tend to live in the headlines of today and forget what people were saying just a short time ago. If you do a simple Google search for recession + [some year] you will find dozens of articles floating around explaining why a recession is looming just over the horizon. For example, I found this article from CNBC explaining why in June 2016 we were right on the doorstep of another economic contraction.
If you dive deeper into that CNBC article the author brings up valid economic arguments why we should be expecting a sudden drop in our portfolios.
What has happened since this article was written? Well, the S&P 500 has only gained about 1,000 points or 50% as of May 2019. Clearly the U.S. economy is more complicated than any of us can hope to understand.
If you pull up a chart of the S&P 500 index you will see what appears to be a cyclical trend of up and down with a general upward slope as you go further in time.
This leads to the belief that you can predict when an impending market crash will occur simply by looking at the trend of the market over a long enough time interval. To test this hypothesis, I have created a sample set of yearly stock market returns. As an experiment, see if you can predict when the drops in value will occur by trying to follow the patterns of the previous yearly returns for a 29 year time horizon. When you finish, see how your results compare to the simple strategy of continual investment in the market.
|Year||Your Portfolio||Continual Investment||Percent Change In U.S. Stock Market||Your Choice|
What Would You Do With Your Hypothetical Portfolio Next Year?
The return sequence used above is actually the historic yearly returns for the S&P 500 from 1990 to 2018. By playing along you should have realized just how hard it is to predict patterns in the stock market.
One of the most important things I came to realize in investing is not to forget my ultimate goal. For example, in almost all my investing strategies I am looking at long-term returns years down the road. What happens over the course of days, weeks or months really doesn’t have a large impact on my long-term strategies. Given that the average length of a U.S. recession is somewhere around 18 months, these drops in my portfolio value no longer worry me.
I’ll admit that despite this information, there is still a built-in human tendency for people to want to do something when recessions and market downturns cause a drop in their portfolio. By looking at mathematics we can prove what the right answer should be.
The calculator below provides an opportunity to experiment with a simple portfolio choice of cash and stocks or just stocks. The calculator assumes you have some initial amount of capital and will contribute more capital each year (at year’s end) somewhat like an IRA or 401K.
The choice the calculator lets you experiment with is whether you should keep some of your capital in cash (waiting for a market correction to add to your stock position) or simply put it all in stocks and ride out the years. To simulate stocks, the calculator uses the true yearly mean (average) and standard deviation (variability) of the S&P 500 to develop a hypothetical future return sequence for stocks.
This does not mean that this calculator predicts the future - it only simulates one POSSIBLE future outcome. Mathematically, I assume that the S&P 500 returns are normally distributed around this mean and standard deviation.
If you want to use this calculator, please note that the results in no way should be construed as investment advice and are shown here for educational purposes only. Should you choose to implement any strategies based on this information given you do so at your own risk.
Lastly, this calculator assumes you only care about overall returns and are not concerned with portfolio volatility (such as a retirement account you will not touch for many years). Adding a cash position to any portfolio will decrease volatility and help to preserve principle in times of market corrections.
If you are technically inclined and would like to view or modify the source code behind this calculator you may do so here.
Have fun and remember words may deceive but math never lies ☺
This calculator allows you to experiment with a basic two asset (cash and S&P 500) portfolio as described above. The basic premise of this calculator is to determine the most efficient split between these two assets and if there is an optimal rule of moving cash to the S&P 500 after a market correction. Some of the key aspects of this calculator are: