After 2020's Market Crash, How Should Investors Prepare?
What the shortest market crash in history can teach us about weathering volatility.
Scott Halver: Looking at the market today, it might be easy to forget where we were at around this time last year. It was February 2020, that the stock market plummeted. The COVID lockdowns followed. One year later, we're still feeling our way out of this pandemic, but the market has made a full recovery and then some. Still, the movements of this year reminded us of the pain and uncertainty of market crashes. Are these kinds of drops normal? Was anyone ready for it? What should an investor do now to prepare for the next crash?
The global financial crisis and subsequent market crash that ended in 2009 has been described as a "black swan," a unique negative event that could not be foreseen because no similar events had occurred in the past. However, if we look at historic data, we can see that there is a long history of market crashes.
Financial researcher Larry Siegel came up with a more fitting term "black turkey," an event that is everywhere in the data, it happens all the time, but to which one is willfully blind. Between 1871 and March 2021, we can see 18 black turkeys in the U.S., which would be market declines of 20% or more. That means a black turkey happens about once every eight years. The pattern is similar in almost all developed markets. Now this isn't to say that anyone could have or should have seen the COVID-19 crash coming. And the good news is that markets have already recovered and gone on to new highs. It was actually the shortest crash in the long history of market crashes. Yet with all market downturns, no one knows how long one will last.
Steve Wendel: It's perfectly natural. Right now people feel unsettled because of the reality of a global pandemic, and the wild swings in the market that we've seen, and also because of how our minds are wired. When the markets dropped 10%, we are seeing up and down. When they go down 10%, it's a natural way to think that they will continue to go down. So, we worry about that. We worry about what that means for our livelihood, what it means for our portfolios and our ability to retire comfortably.
Halver: This volatility may make some investors want to sell out of stocks completely when there is a crash. However, most investors should not make drastic changes. If we look at a U.S. investor who sold out of stocks in 2009 and then reinvested one year later, we can see that they ended up with much less return compared to someone who stayed invested.
Christine Benz: If you encounter market volatility and you expect to need money within the next, say, two to five years, it's probably not too late to reduce your equity allocation. Yes, in a lot of ways you're locking in losses. But the idea is that you're derisking that money that you expect to spend soon. On the other hand, for funds that you won't need for a while, say five or 10 years or even more, you probably want to leave those invested in stocks. Let more of your portfolio heal and grow for the future.
Halver: Investors' behavior in volatile markets often works against their long-term plans. What can investors do to keep their behavior in check?
Wendel: First, we want to externalize our own rules, how we want to respond, and what we value in investing. So, write out your goals, write out your rules: I trade under this price to fair value, et cetera. Second, take that and create a commitment around it. So, signing it matters, it makes a personal commitment, signing that statement. You can also make it a social commitment by giving it to your spouse, giving it to your advisor and saying these are the rules that I want to follow. And then third, you can use that and other techniques to add friction. Setting a cooldown period before making any major changes, say a three-day window after which it's OK to make a change, but you have to wait those three days to think clearly about the changes you want to make.
Halver: Black turkeys are unsettling, but they are an expected part of investing. If you focus on controlling your own behavior, matching your mix of investments to your time horizon, and maintaining a focus on the long term. You can weather the next market crash, ultimately reaching your financial goals.