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Passive investing and stock market crashes

Photo of Lars Kroijer hedge fund manager turned passive index investing author

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.

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 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.

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{ 16 comments… add one }
  • 1 The Rhino May 15, 2014, 10:38 am

    looking forward to my first crash where i have a bit of skin in the game

    lost a little in 2000, nothing in 2009 so its the next one thats going to get me

    will be interested to see how i behave

  • 2 ermine May 15, 2014, 1:38 pm

    erm..cough there’s at least one fellow not a million miles from here who did ok in 2009 😉

  • 3 The Rhino May 15, 2014, 2:16 pm

    @ermine prob should say ‘since’ 2009 rather than ‘in’ 2009

  • 4 ermine May 15, 2014, 10:36 pm

    @The Rhino it’s a moot point since the low water mark was March/April ISTR and much of the pullback happened before the year was out. Either way, TI’s achievement isn’t to be sneezed at at all. And it’s not pound cost averaging either – he was definitely running the other way to the rest of the market!

  • 5 The Investor May 15, 2014, 11:47 pm

    Generous to mention, thanks, but of course I was also buying in 2008… 🙂 I’ll take some credit for the general strategy but the exact timing of that post was pretty fluky… 😉

  • 6 gadgetmind May 16, 2014, 10:40 am

    Between 2010 and the end of last year, I put over £250k of money into equities, some of it from earnings, some of it from cash accounts, and some from a critical illness insurance payout (all sorted now, fingers crossed!)

    It’s looking good so far, but there were rough patches during 2011 and the sovereign debt crisis, and there is still a lot of risk around.

    If equities crash, will I be able to put emotion to one side and rebalance back to my target allocation? Well, I think so, ‘cos I’ve been like a kiddie in a sweet shop during the previous “sales”!

  • 7 Jonny May 16, 2014, 12:19 pm

    @gadgetmind

    It all depends on the amount of pocket money you have at the time of the sale!

  • 8 gadgetmind May 16, 2014, 1:09 pm

    True, and we were, um, “lucky” with the insurance, but I did make a conscious decision to take our cash allocation very low, and even moved some fairly big chunks from cash accounts into my SIPP.

    Since then, I’ve been rebuilding the cash, often by selling equity investments that have doubled in capital value and paid nice dividends too.

    Of course, come “next time” will having got it more or less right before help or hinder? Time for some fairly mechanical rebalancing strategies methinks!

  • 9 ChrisCD May 16, 2014, 4:32 pm

    So outside of Re-balancing, does it make sense as a passive investor to take profits and move into cash and then re-build the equity side of things. I realize you never know whether something will move up or down, but sooner or later this market has to move down. Taking the profits would lock in those gains from the run-up. Thoughts?

    cd :O)

  • 10 theescapeartist May 16, 2014, 4:47 pm

    Another interesting and relevant article…but there is one part of this that I didn’t agree with:

    “First of all, after bad declines it’s likely that the future riskiness of the market has gone up a lot.”

    Isn’t this confusing volatility with real risk? After a bad decline, the (historic) volatility has gone up. But, as Warren Buffett reminds us, that is not true risk. Real risk is permanent loss and impairment of capital. If the market has gone down by 25% in a normal market panic, it is probably now better value than it was before the panic. You own the same stocks as you did before. At a lower price, the real risk of investing (ie committing new capital) has surely gone down?

  • 11 Andy May 16, 2014, 10:48 pm

    I have been investing through the 2001-2003 and 2008/9 market crashes. At the time I was an active investor investing directly in shares. With hindsight, I made reasonably good decisions during 2001-2003, but did worse in 2008/2009. Although I had spare cash to invest in 2008/2009 I had a larger portfolio by then and found it difficult to decide what to invest in during all the market noise. I did make some investments in financials too early, which didn’t turn out too well.

    It was only after the financial crisis that I read Smarter Investing after coming across a mention of it on Retirement Investing Today and started switching to more passive investments. I believe that whenever the next market downturn occurs, I will have less stress and the advantage of knowing that I just have to rebalance my investments and not the additional dilemna of stock selection.

    @ChrisCD, I think the evidence shows most people get market timing wrong. Don’t be one of those people.

  • 12 SemiPassive May 17, 2014, 9:51 am

    Agree with theescapeartist, in these situations volatility has gone up, maybe even short term value at risk, but that doesn’t take into account PE ratios and other valuation metrics that have moved in your favour.
    I think one (massively oversimplistic) rule to protect people – often from themselves as much as market crashes – is never have more than 50% of your net worth in equities, and never have less than 25% of your net worth in equities.

  • 13 dearieme May 17, 2014, 2:50 pm

    “never have more than 50% of your net worth in equities, and never have less than 25% of your net worth in equities.” That’s an interesting suggestion.

    An MSE commenter recently suggested to a 36-year old enquiring about his pension: “Put 50% into a globally diversified cheap equity fund or ETF (Vanguard?), 20% into inflation protection e.g. an ETF of TIPS (the US equivalent of index-linked gilts), 20% into something cash-like (perhaps a fixed interest gilt with a shortish maturity e.g. four or five years), and 10% into Gold Bullion Securities. I’d rebalance once per year.” Is that reasonable? Too conservative for a youngish chap? ………

  • 14 theescapeartist May 17, 2014, 2:53 pm

    SemiPassive – that’s right, after the fall you own the same index / underlying securities but as you say, the valuation metrics are now better.

    Your 50% maximum equity allocation rule of thumb will definitely help an investor remain calm through a crash. The other side of the argument is set out best in “Winning the Losers Game” where the author argues for higher equity allocations…but only if you have the ability to calmly sit out market storms.

    I think many investors will be better able to handle a higher equity allocation if they hold index trackers (or a mix of trackers plus direct shares) rather than just direct shares. It somehow feels less personal when you hold an index tracker and it goes down!

  • 15 BBQPimmsMonster May 17, 2014, 10:48 pm

    I’m pretty sure you won’t release this post – but any chance you could ask Lars for a new photo. He looks about 3 pimms deep at the afternoon bbq…

    His image doesn’t seem as on par with the rest of your site – which is always a great read.

  • 16 Lars Kroijer May 21, 2014, 7:32 pm

    Thanks for the many comments. The point on whether volatility/risk has gone up was more one of observing data for past crashes than me having a view on whether actual risk of equity markets increases after a crash. In all cases I have looked at, what happens after a market crash is that the forward looking risk increases. This is the case if you look at VIX or even longer (+1month) equity options. You could of course take a different view to this and say that actual risk is lower, but then you could profit from being right with that view by trading the volatility/ options (please don’t do this unless you have experience w options – that market is filled w vultures). When I referred to the equity risk premium going up it was to say that there is emerging academic work suggesting that there is a correlation between forward looking volatility and equity risk premium going up. That kind of makes sense – if markets are expected to be riskier going forward people demand higher expected returns to hold the market. A problem with this analysis is however that there may not be quite enough data to be categorical about that conclusion. And also, just because the equity risk premium (so expected equity return) may have gone up, it does not mean that you can’t lose a lot. Just that on average you’d make more to hold the now riskier markets. Sorry for the bumbling response. Hope it makes a bit of sense. Lars

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