Passive investing and stock market crashes

Former hedge fund manager Lars Kroijer now advocates passive index investing as the best approach for mainstream savers. As well as his occasional contributions to Monevator, you can read his book, Investing Demystified.

Surveying their portfolio in the aftermath of the 2008/9 financial crisis left many investors feeling aghast. Some lost far more money than they thought possible.

Often they did so while their house and other assets also plummeted in value.

Their gut reaction may have been to sell out of their equity exposure near the bottom of the crash, only to miss out on the great rally that followed.

“The old story of retail investors abandoning their plans at the first sign of trouble,” lamented the financial planners.

But I don’t think it is that simple.

A good financial plan is a great start

If you’re a regular Monevator reader, you’re probably ahead of the game when it comes to investing.

You likely have a well-thought out financial plan, based upon:

• An assessment of your likely earnings and subsequent needs in retirement.

• A diversified portfolio that’s appropriate for your risk tolerance.

• A sensible guesstimate of your likely returns.

• A focus on cheap passive funds and cost-efficient brokers.

• Regular monthly savings to make it all happen.

Does that sound like you? Congratulations, you are genuinely doing very well.

But unfortunately that’s not the end of it.

No plan survives contact with the enemy

When we take charge of our investments, it’s up to us to keep an eye on our portfolio and our financial plan, and to adapt them to changing circumstances as well as the passage of time.

Big moves in the market might change our outlook, for instance.

Imagine a scenario where the stock market moves up 50% in a year. We would be remiss if we didn’t somehow take our improved financial situation into account in our forward planning. Our now-higher asset base might mean we can reach our financial goals with far lower risk, which could prompt a shift in our portfolio towards safer assets.

And it’s not just the market that changes. Our personal circumstances change too, and that in turn can impact our plans.

You’re promoted or fired, receive an inheritance, get divorced, your car is stolen without insurance, your tax circumstances change, you have a child – it all makes a difference.

How often you review your portfolio in the light of these changing circumstances is up to you.

Personally I think it’s worth doing so at a minimum yearly, as well as on an ad hoc basis when there’s a lot of turbulence in the financial markets or in your personal life.

Since you should plan to rebalance your portfolio periodically anyway, that is as good a time as any to review its composition in the light of these changing factors.

Reacting to disaster

The most important thing is to act in a controlled manner, and to try to anticipate how you’ll respond to different situations.

In other words: Don’t panic!

This can be easier said than done. When crashes like 2008 happen, there is a natural tendency for everyone to have a view on the markets. Financial news dominates the headlines and is a topic of conversation at the office, gym, mealtimes, in your home, and everywhere else.

When everyone is talking about it, how can you not have a view?

But the point is that as passive investors we recognise that we do not have any special insight or ‘edge’ when it comes to knowing what will happen after a crash, no more than at any other time. That’s why we’ve chosen to follow the index-tracking path. (Of course, we believe the evidence is that the vast majority of other people have no such insight, either!)

So while it’s tempting to take a view on the market when everyone else is and when we are perhaps instinctively looking for a reason why we lost so much money, we shouldn’t be fooled into doing so.

Or at the least, we can have an opinion but we shouldn’t act upon it recklessly and so become market timers.

With the benefit of hindsight, many people say they felt the market would rebound after the lows of 2009. But just because there is great market turbulence – that does not mean that an investor is suddenly better able to predict market movements.

As passive investors, we don’t consider ourselves smarter than the average pound invested in the market. That’s why we buy the index, after all.

That average pound put the FTSE 100 at an index value of barely 3,500 in early March 2009. That was the consensus opinion of all the money invested in equities at that point in time.

The fact that four years later we saw the same index much higher and approaching its all-time peak does not mean that we should have or could have predicted as much in March 2009.

Beware of hindsight bias

When they look back at the 2008/9 crash – or at any of the many that preceded it – people often have a sense that was always going to be a bottom somewhere, and great profits for the investor who can find the bottom.

And clearly that has mainly been the case throughout the history of most Western markets.

If you had stayed the course or invested more at exactly the right point in March 2009 in the UK or July 1932 in the US, then yes, you would have made a lot of money.

But you did not know that then.

For all you knew at the time, March 2009 was just a precursor to an even worse decline in the market.

Besides in reality you were scared to death.

There is no guarantee that markets will bounce back after a decline (which reminds me of the funny trader witticism: “He who picks bottoms gets smelly fingers…”). Just ask investors who bought Russian equities in 1917!

But that does not mean there is nothing we can do about the propensity of stock markets to crash now and then.

Buffered by bonds

First of all, after bad declines it’s likely that the future riskiness of the market has gone up a lot. While that does not tell you about market direction, at least you can prepare yourself for the increased risk.

Those willing to bear the extra risk will probably earn commensurate higher expected returns – there is good academic evidence that the equity risk premium goes up with the risk of the market – but they have to be willing to accept that a lot of money can be lost, too.

We know that losses like those in 2008/9 do happen with some frequency. It’s at times like these that you will benefit from a more conservative allocation policy – a portfolio that includes allocations of government bonds and perhaps cash. They are derided as boring and low return or even ‘no-return’ when the stock markets are going up, but they earn their place during steep declines.

These boring assets buffer your portfolio’s value – and your nerves – and hopefully stop you selling your equities in desperation when things get rough.

Avoid having to make bad decisions

Whether your portfolio goes down a little or a lot, a market crash can make your financial plan look pretty sick.

And when that happens, there are no easy fixes.

Instead you are faced with several unpleasant alternatives:

• You can find a way to put more money into your savings.

• You can accept a lower income in retirement.

• You can retire later.

• You may decide to re-allocate between the minimal risk asset (that’s government bonds for UK investors) and equities, if the large fall in your net worth has impacted the risk you’re willing or feel able to take. (Obviously this is a re-allocation that’s best made when stock markets are up, not down…)

Over time the stock market may recover, and with luck you’ll be able to tweak your financial plan again. If you do so because your shares have soared, then the options will be much more pleasant this time around!

But you shouldn’t rely on a recovery in the short to medium-term to be confident about your financial future.

Like the Boy Scouts: Always be prepared

You might say it’s closing the stable door after the horse has bolted to reduce your risk exposure after a market crash, and that’s obviously to some extent true.

Though it sounds like annoying hindsight, investment allocations are really about trying to ensure you never find yourself in the position of making forced or panicky sales.

Stress test your retirement plan and try to have a sufficient buffer of safer assets to stop you selling equities at what might be the bottom of the markets.

Over the long run, the returns from equity markets are likely to far exceed government bond returns, but they will also be far more volatile and periodically lose you a lot of money.

Make sure your allocations allow for that, especially as you get closer to when you’ll need the money.

Lars Kroijer’s Investing Demystified is available from Amazon. He is donating all his profits from his book to medical research. Check it out now.