Epic Stock Market Crashes - Guide on how to take advantage of the next recession
The Stock Market is a powerful money-making machine that can make you rich and financially independent
Stock Crashes are part of the game. It’s a complex topic and I divided it into three sections:
- How much can I lose and how long will it last? Let’s face it, in theory you can lose it all. There have been instances in history when some investors lost all their savings. What’s poorly understood is that in reality, it’s almost impossible to lose money in the long term if you follow common sense investing rules and you will likely recover your money relatively quickly. How long will the downturn last? It can be quick. In the US the worst day was a 23% loss for the Dow Jones Index. Often it will take a year or two
- Can I do something to prepare for it? Absolutely – it’s all about prevention and limiting the damage. If you review some of the previous market crashes you will understand that there are powerful weapons at your disposal to mitigate downside risk without technical knowledge. Preparing for a crash includes diversifying (but not too much), getting international exposure and ‘hedging’ with some Bonds/Inflation Protection to protect your portfolio from your emotional decisions
- Once you are prepared, can you take advantage of the next market crash? Yes – Dollar Cost Averaging with additional injections trumps any crisis (yes, Japanese style, too), reinvesting dividends and re-balancing will also help tremendously. A too conservative portfolio can hurt you. Frankly, if an extreme event strikes all markets at the same time, you will have other things to worry about than checking your broker account
In the meantime, learn how to benefit from stock market crashes, take calculated risk and enjoy the returns of the Stock Market – probably the best source of passive income
What do you know about Bears?
Japanese warning sign with a quiz about Grizzly Bears in the northern Island of Hokkaido (Shiretoko National Park – 知床国立公園)
Cycling in Shiretoko was not the most relaxing despite breathtaking views – it’s the most densely populated bear area in the world (yes, even including Alaska and Canada’s Yukon Territory)
How do people lose money in the Stock Market?
In the wrong place...
- During some of the most spectacular market crashes investors lost all their money – circumstances have been quite extreme in most cases: wars, revolutions, changes in political regimes – all seemingly remote in today’s developed markets
- A lot of others were restricted to very specific countries – unlucky were those that didn’t hear about diversification
Select spectacular market crashes over the last 100+ years
... At the wrong time
In any conversation about long term investing the Great Depression or Japan’s Lost Decades will come up
Below are a few facts you need to know
I also describe what would have worked in the past – the goal is not to forecast how the next downturn will look like but be robust to most scenarios
The Three Grizzlies - profiles of painful downturns
Crashes brought opportunities
This guide is not meant to be exhaustive but gives you the possible profiles of recoveries
Why did I select those? It largely boils down to answering the questions:
- How you can prepare for the unpredictable?
- How do you take advantage of a recession or a market crash?
With that in mind, I listed best practices to help you construct a portfolio
There are also theories that the rise of algorithmic trading may amplify future crashes (and may make them shorter) with possibly shorter recoveries as well similar to what witnessed during COVID-19
The Mainland Grizzly - Great Depression (US)
Great Depression (Loss from Market Peak on $1,000)
- This is a widely documented crisis with a profound impact
- It took 7 years to break even from the 1929 crash and less than 5 from the trough in 1932 (25 Years to Bounce Back? Try 4½)
- The reality is more subtle than the NYT article above of course since there have been another few years of negative returns
- The fact is, this very much a black swan series of events with Great Gepression followed by World War II
- Above is the drawdown profile adjusted for deflation (and then inflation) with reinvested dividends. The initial deflation has made Bonds attractive and reduced real losses on Stocks (more on that in the sections below)
The Kodiak Grizzly - Inflation Shock (UK and other countries)
Inflation Shock in the UK (Loss from Market Peak on £1,000)
- The Great Depression is widely referenced and the below Japanese case is frequently discussed when people talk about their FIRE Strategies
- However, I think that the most dangerous crisis that occurred in the past century is largely ignored – the 1970s Price shock.
- The real price of imported oil in the U.S. increased 6-fold in the 1970s
- Initially, stocks were hit the hardest, declining up to 50% within 18 months in the US and 73% in the UK
- Later, as inflation accelerated, bonds (e.g. US Treasuries) suffered as well, declining up to 40% by 1981. Yes, your Equity and Bonds would be significantly down – at the same time
- Above are the inflation and dividend-adjusted drawdowns for a UK 100% domestic Equity Investor
The Hokkaido Grizzly (ヒグマ) - Lost Decade (Japan)
Japan's Lost Decade (Loss from Market Peak on ¥1,000)
- You would be hard pressed to find somebody who hasn’t at least heard of Japan’s Lost Decade(s)
- It’s a popular topic people raise as soon as early retirement and living off an investment portfolio comes up in a conversation
- Since this is the hottest topic with regards to Long Term Investing (and it shouldn’t be – look at the 70s above) I have expanded on it in the section below about how to prepare for such a crisis since the portfolio consequences of this crisis were actually (in retrospective – I know that’s easy) one of the easiest to avoid
- Above is the decades-long drawdown adjusted for dividends and periods of deflation (mainly) and some inflation in between (overall averaged a 0.5% annual inflation since 1989) from the perspective of a Japanese 100% domestic Equity investor
Did you know that Black Bears can be brown?
Grizzly Bear can be dangerous. The largest ones are located on the Kodiak Island in Alaska. Black Bears are usually less dangerous because they often attack only when they have no other alternative
Black bears are easily confused with Grizzly bears because it’s not the colour that defines them (an easy way to spot the difference is the shape of ears)
Markets can be more tricky – a black bear (described below) is an opportunity, a grizzly (described above) can be a bit more challenging. And you initially can’t tell the difference
Black Bears - "V-shaped" market recoveries
- These may be painful at first but overall they are probably the best buying opportunities in their decades
- The below graphs show the drawdown from market peak but don’t consider the prior rallies, to illustrate that consider the following:
- In the Flash Crash in 1987 the S&P 500 (adjusted for dividends) finished the year flat despite the worst one day performance of the Index in October – On Black Monday the Dow Jones lost c. 23% and S&P 500 just over 20%
- The recovery represented positive returns when you take January 1987 as a starting point
1987 Flash Crash (Loss from Market Peak on $1,000)
- We are yet to see the full extent of the COVID-19 damage on the Economy but as of August 2020 the S&P 500 has already recovered all its losses. The NASDAQ is up 25% in 2020.
COVID-19 Sell-Off (Loss from Market Peak on $1,000)
How do I prepare for the unpredictable?
The idea of this analysis is not to predict outcomes as I fundamentally believe most people waste their time trying. Rather, it is to learn from the past to build the most robust portfolio to withstand most of the possible situations. Here are the common errors investors made in the past decades and major lessons we have learned from past bear markets
Market Crash Portfolio Protection in 3 Steps
Get Inflation Protection
Get Inflation Protection
1. Why you need International Diversification
How do I select Emerging Market and Developed Market ETFs?
International ETFs can be confusing due to the different naming conventions of the Index Providers – I had a deep dive into the way they work, and hope you can benefit from it as well.
Understand how ETFs track benchmarks to control (i) Countries, (ii) Developed vs Emerging economies, and (iii) Size of companies (large to micro caps) and choose the Best International ETFs for your Equity Portfolio
- International Diversification may have been a lifesaver at some point if you were based in pretty much any country outside the US
- There has been a lot of cases where damage could have been limited by international diversification (arguably, any of the above scenarios including major Asian ones except the Depression, the 1970s, dot Com crisis or the Great Financial Crisis)
- For US Investors it was more a return enhancing tool over the long term (since World Equity Markets tend to be correlated and International Markets tend to see more outflows during crashes) but ultimately history may prove it to be a risk tool as well
- Critics will argue world equities are correlated but this argument is irrelevant. Especially if you are in a small country but even if currently restricted to a large economy the benefits are clear
Are you willing to restrict yourself to one market? Relative performance (by size) of Equity Markets from 1900 to 2020
- Being a Japanese investor in the 1980s you must have been thinking “The Japanese stock market has been a better investment for many years now. It is reasonable to eliminate the rest of the developed world and the US from my portfolio since it’s a drag on the performance”
- Japanese Market represented a higher capitalization the US Market
- In fact, by investing 1,000 ¥ in 1970 your portfolio would have gone up x17 to 17,000 ¥ by the end of the 1980s if you held an equivalent of the Japanese Nikkei vs only x4 from $1,000 to c. $4,000 if you held the S&P 500 (and that’s not even taking into account that the USD lost 60% relative to the YEN)
THE MOTHER OF ALL BUBBLES
bubble in six countries
- In their fascinating Book “Manias, panics, and crashes – a history of financial crises” Charles Kindleberger and Robert Aliber describe an extraordinary time when Japan and Scandinavian countries experienced their largest asset bubbles at the same time – below are some facts related to Japan’s Lost Decade
- Asset price bubbles in major industrial countries are rare; the previous bubble in the United States had been in the late 1920s. Japan had never had an asset price bubble before and neither had the Asian countries
- There were more asset price bubbles between 1980 and 2000 than in any earlier period. Japan experienced the ‘mother of all asset price bubbles’ in the second half of the 1980s. Real estate prices increased by a factor of nine, stock prices increased by a factor of six, and Japanese financial wealth surged. The Japanese economy boomed. Finland, Norway, and Sweden also experienced bubbles in their real estate markets and their stock markets at this same time. Other Asian markets followed.
- A bubble in six or eight countries at the same time is an extraordinary phenomenon; nothing like it had ever happened before.
- The 1980s real estate bubble in Japan was so massive that by the end of the decade the chatter in Tokyo was that the market value of the land under the Imperial Palace was greater than the market value of all of the real estate in California. The land area in California is several billion times larger than the grounds of the Imperial Palace, which meant that there was an enormous difference in the price per acre or hectare. All of the financial values in Tokyo were sky high at the end of the 1980s.
- The market value of Japanese stocks was higher the market value of U.S. stocks, even though Japanese GDP was less than half of U.S. GDP. The comparison between Japanese and U.S. firms in terms of the ratios of the market value of stocks to profitability was even more skewed. The market value of Japanese real estate was twice the market value of U.S. real estate, even though the land area in Japan is 5 percent that in the United States and 80 percent of Japan is mountainous
Below is an example of how keeping the S&P 500 and European Equities would have looked as a major drag to the portfolio for the Japanese in the 1980
Japanese vs. US Equities in the 70's and 80's
….and now if we zoom out
Japanese vs. US Equities since the 90's
Market Crash Portfolio Protection in 3 Steps
Get Inflation Protection
Get Inflation Protection
2. Why you need Bonds
Understand the role of Bonds in your Portfolio
Don’t feel intimidated by the number of asset classes – investing can be simple and you don’t need to understand all the technical details. There are only three things you need to watch out for when assessing assets for their diversification benefits and you will realize how bonds can be useful
- This is the big one. Remember those horrible drawdown charts at the top of this guide? It won’t be half as bad if you get reasonable amount of Bonds which will protect your portfolio from your worst enemy – your emotions
- But let’s face it. While a lot of analysts and some of the smartest retail investors (Bogleheads) claim that you need to stay course in tough times I personally think that they are living in a fantasy world – what’s the likelihood you would have additional savings to inject during a Great Depression? There would be more vital needs and high likelihood of income loss (job). COVID-19 is not dissimilar with that regards (likelihood of job loss combined with healthcare costs and helping out family).
- However, if you already had Bonds then at least you could re-balance and buy cheap stocks benefiting from the market crash
- Alternatively if you really need cash you can withdraw it from your Bond allocation (but you will increase your risk profile) to avoid selling Equities at the worst possible moment
- Bonds also protect you in all deflationary scenarios – during the Great Depression (1928 -1940) the cumulative real total return of 10-yr Treasury Bonds was 100% that you could have sold to buy Equities
You may not always be able to stay course (and inject savings)
Market Crash Portfolio Protection in 3 Steps
Get Inflation Protection
Get Inflation Protection
3. Why you need Inflation Protection
Blind trust in Bonds can be fatal
- Ok, you may think the following example is extreme. And I tend to agree. German bonds from WWI lost 95% of their value relative to cash in the year or so after Germany surrendered.
- Despite earning more than a 900% excess return since then, investors never recovered their wealth – this may be a very specific case, again a black swan (let’s not dive deeper)
- But if you look at the 1970s and ALL major developed markets, while you may think this scenario is remote it clearly can’t be totally excluded (given recent Central Bank activity) . Oil and food shocks boosted inflation and by end of the 1970s, bond yields had increased to double digit levels.
- As the FT summarized it well “Investors not only earned negative real income returns but also suffered punishing capital losses. No wonder a bond came to be considered an unmentionable four letter word and bond investors came to believe they had in effect been slaughtered“
Inflation Protection benefits (Loss on $1000 from Market Peak)
- Inflation Linked Bonds were not available back in the 1970s. But another Inflation Protection instrument is Gold
- I don’t have high quality Bond Data for the UK for this period but US markets reacted in the same way (albeit not as bad as the UK). I looked at the S&P 500 and Long Term Treasuries.
- The Red surface is the drawdown profile on 60% Equity / 40% Bonds Portfolio
- The Yellow one is 60% Equity / 20% Bonds + 20% Gold
- Re-balacing (see section below) also plays a role here – I have assumed it’s done annually, so you effectively sold expensive Gold and bought Equities during that period
- If we take 1970 as a starting point (and Jan 1986 as end date) the annual return adjusted for inflation was 5% for the Portfolio with Gold vs. 2.3% without it
How do I take advantage of a Market Crash?
- There are empirically and research proven ways to benefit from market crashes – even if you get the timing completely wrong – Investing regularly (if you have the ability, which most of us should if we control expenses) will trump ANY crisis
- Assuming you reinvest dividends and rebalance you will end up buying the Stock market at a discount
- To remain robust in worse times create flexibility with side revenue sources or options to reduce spending
- Think also about reducing taxes when you incur losses loss harvest
Take advantage of a Market Crash in 3 Steps
Buy the dip
Most people would still have their jobs (and ability to invest) in a typical bear market
But what if I get the timing wrong?
Look, the above worst case drawdown charts are assuming you invest at the worst possible moment. And you invest all of it in one go. In reality rarely anyone invests lump sums.
But what would happen if you did just that?
REGULAR INVESTING TRUMPS ANY CRISIS
BOB - US' WORST MARKET TIMER
- In 2014 Ben Carlson wrote a piece about the worst market timer named Bob
- “Bob was a diligent saver who started working at 22. His commitment was to save 2k/year through the 70s, 4k/year through the 80s, 6k/year through the 90s, then 8k/year until retirement
- He started out by saving the $2,000 a year in his bank account until he had $6,000 to invest by the end of 1972. The market dropped nearly 50% in 1973-74 so Bob basically put his money in at the peak of the market right before a crash. Yet he did have one saving grace. Once he was in the market, he never sold his fund shares. He held on for dear life because he was too nervous about being wrong on both his sell decisions too
- Bob didn’t feel comfortable about investing again until August of 1987 after another huge bull market. After 15 years of saving he had $46,000 to put to work. Again he put it in an S&P 500 index fund and again he invested at a market peak just before a crash
- The final investment was made in October of 2007 when he invested $64,000 which he had been saving since 2000.
- He rounded out his string of horrific market timing calls by buying right before another 50%+ crash from the credit blow-up
Luckily, while Bob couldn’t time his buys, he never sold out of the market even once. He didn’t sell after the bear market of 1973-74 or the Black Monday in 1987 or the technology bust in 2000 or the financial crisis of 2007-09. He never sold a single share
Investing regularly - single best accelerator of wealth
(The Video total contribution is $128k and differ from Ben's first analysis - conclusions are the same!)
Bob the Millionaire
Now that you’ve read about Bob you may ask how did he do?
Even though he only bought at the very top of the market, Bob still ended up a millionaire
- After a net contribution of $184,000 his portfolio is worth $1.8m before inflation and $800,000 after adjusting for inflation
Bob, US Worst Market timer is close to being a millionaire (after inflation)
Kumiko (久美子) - Japan's Worst Market Timer
- If you thought Bob was unlucky consider Kumiko
- Kumiko is Japan’s worst market timer (she invests in Yen but I keep same amounts to make her case easier to compare with Bob)
- She invested the same amount of money over time as Bob, but she lives in Hakodate, on the Japanese island of Hokkaido (yes, that same island with the highest concentration of Grizzly Bears in the World)
- Not only did she miss the greatest bull market ever but also didn’t compound interest over 20 years when Bob had already skin in the game
- So she decided to deploy 20 years of hard earned savings in 1989 at the peak of the mother of all bubbles
- She thought she’s seen it all when her savings plunged c. 70% by 1998 (dividends offset some losses) so she prepared for another injection of her savings. The rally until March 2000 comforted her that the time was right and she invested another 60,000 at the peak of the dot com bubble
- Similar to Bob she didn’t have much luck in 2007 either when she deployed another 64,000
Kumiko (久美子) realized, too late, that Japan's relative stock market size was a historical aberration
- Kumiko invested at the worst of all possible times in the worst market and she had only 30 years of returns compared to 50 for Bob
- How did she do? Well, Kumiko is not millionaire yet but she’s considering adding some bonds/inflation protection and investing overseas from now on!
- Her portfolio is now worth 265,000 after contributing 184,000. After inflation, the value is just over 230,000. Maybe not that bad for the worst timing ever.
Kumiko's (久美子) portfolio value after Japan's lost decade(s), dot com and GFC Crashes
When you see a bear it's too late to run away from it
Bear sprays work 90% of the time, but nothing is certain. Like in markets.
You will put your life in danger if you start running away – an easy pray for bears that I saw running at 40 mph, climb trees and swim in the sea. Don’t worry – unless they just woke up from hibernation their main food sources remain berries or wild salmon
Alaska is a great place to see them in the wild (drop me a message if you want to know my safe spots)
Compound Interest is the 8th Wonder
In the long run, no matter the severity of the crisis if you set up your portfolio correctly you will reap benefits of the most important force that impacts wealth – compound interest
Understand why time matters and your risk profile is paramount
The benefits of reinvesting dividends are propelled by simple math. Both new investments (like Bob’s or Kumiko’s) and reinvesting dividends work wonders. I wrote about it in the principles that guide me in my personal investing
Take advantage of a Market Crash in 3 Steps
Re-balance your portfolio
This aspect necessitates a whole different guide to re-balancing but the idea boils down to intelligent timing of your trades
For example, say an original target asset allocation was 50% stocks and 50% bonds. If the stocks performed well during the period, it could have increased the stock weighting of the portfolio to 70%. The investor may then decide to sell some stocks and buy bonds to get the portfolio back to the original target allocation of 50/50
The key is that it gives you a sense of control
Opportunity favors the prepared mind
Buy low, sell high (purely rule-based – no arbitrary decision from your side)
Essentially, you are reaping the benefits of the portfolio preparation for a crisis steps that I explained earlier (Bonds/Inflation Protection) and benefit from it at the best time (when Equities are cheap)
Take advantage of a Market Crash in 3 Steps
Create Flexibility and optimize
Create flexibility and use tax-loss harvesting
- This analysis focuses on long term investing but ignores any withdrawals (which merits another analysis and de-risking of your portfolio before retirement)
- As we’ve seen the single most important factor in building wealth is regular investing
- To allow for that spending reduction flexibility and/or additional income that can be used for investment is paramount
- Of course, selling individual loss-taking positions in taxable accounts (aka tax-loss harvesting) can help reducing your tax bill
The big picture
Be cautiously optimistic
It’s one of those phrases Bankers use a lot.
Why? Because it’s saying something without really saying anything.
However, in this case it’s a good way of defining things. You need to look at the bigger picture (Stocks tend to go up in the long run) but hedge your downside and remain cautious
Doomsayers will ultimately be right
Active vs. Passive
But in the end markets bounce back, and the worst declines quickly revert. If your portfolio is set up these periods will feel more like an opportunity cost on other things you could do with your money rather than real losses.
It’s choice you need to make – do you have ideas to develop a business or invest in real estate and actively manage it?
These may prove superior to Stocks, but I am yet to find out a better way of getting passive income than investing – a powerful money making machine
Wildcamping in Bear Country
Falling asleep when you’re in Bearland is not easy but you only control certain things – and you should focus on them
If you ever go to Japan, don’t miss out on Hokkaido – Shiretoko National Park and Shakotan Peninsula are my personal favorites. Happy to provide you with some recommendations
Let’s summarize what we know:
- By investing internationally you avoid country-specific risks and although equities are correlated nowadays this is very important to avoid any home bias and potentially increase returns in the long run
- Stay diversified with broad Indices e.g. Dow Jones 30 is too narrow (only 30 stocks)
- With Bonds and Inflation Protection Bonds/Gold you are protected in case of deflation and inflation but most importantly it’s a protection from your own irrational decisions (your biggest enemy in becoming wealthy)
- These protections really start paying off during a crisis when you can reap benefits using re-balancing and buying cheaper equities
- But the key, unless it’s an extreme down-turn is to keep buying equities and reinvesting dividends – this will almost trump any crisis – because in the long run (world) equities always go up
- Kindleberger, RZ Aliber , ‘Manias, panics and crashes: a history of financial crises’ (2011), Google Books
- Donald Bernhardt and Marshall Eckblad ‘Stock Market Crash of 1987′ (November 2013), Federal Reserve Bank of Chicago
- Melissa Saphier, Karen Karniol-Tambour, Pat Margolis, ‘Geographic Diversification Can Be a Lifesaver, Yet Most Portfolios Are Highly Geographically Concentrated’ (February 2019), Bridgewater Associates
- Elroy Dimson, Paul Marsh, and Mike Staunton, ‘Triumph of the Optimists: 101 Years of Global Investment Returns’ (2002), Princeton University Press
- CS, ‘Summary Edition Credit Suisse Global
Investment Returns Yearbook 2020′ (February 2020), Credit Suisse
- Mark Hulbert, ’25 Years to Bounce Back? Try 4½’, (April 2009), New York Times
- Ben Carlson, ‘What if you only invested at Market Peaks?’ (February 2014), A Wealth of Common Sense
- Anupam Dutta, ‘COVID-19 and oil market crash: Revisiting the safe haven property of gold and Bitcoin’ (November 2020), ScienceDirect
- Juan C.Reboredo ‘Gold can act as an effective safe haven against extreme oil price movements’ (February 2016), ScienceDirect
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HAVE A QUESTION ABOUT INVESTING?
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Good luck and keep’em* rolling!
(*Wheels & Dividends)
How much can I lose? Let’s face it, in theory you can lose it all. There have been instances in history when some investors lost all their savings. What’s poorly understood is that in reality, it’s almost impossible to lose money in the long term if you follow common sense investing rules and you will likely recover your money relatively quickly
It varies depending on the crisis. It can be quick. In the US the worst day was a 23% loss for the Dow Jones Index. More often it will take a year or two. Diversification plays a key role to reduce risks and recover quicker
Preparation is key. Preparing for a crash includes diversifying (but not too much), getting international exposure and ‘hedging’ with some Bonds/Inflation Protection to protect your portfolio from your emotional decisions
You need to get prepared before the recession and then use the preparation to reap the benefits. Preparing for a crash includes diversifying, getting international exposure and hedging with some Bonds and Inflation Protection. You can then take advantage using of the recession using Dollar Cost Averaging with additional injections trumps any crisis (yes, Japanese style, too), reinvesting dividends and re-balancing
There are empirically and research proven ways to benefit from market crashes – even if you get the timing completely wrong – Investing regularly (if you have the ability, which most of us should if we control expenses) will trump ANY crisis
Assuming you reinvest dividends and rebalance you will end up buying the Stock market at a discount
Investment timing is not the most important factor. Saving and investing regularly trumps any crisis. Even if you invested at the top of each market in the US and Japan you would have made substantial gains over time
It depends on the country.
In the US the Great Depression the maximum drawdown was 85%. In China and Russia it was 100%. Stock Markets lost between 75% and 91% in Japan, Taiwan or Korea. The worst drawdown for the UK occurred in the 1970s and was 75%
During the last 120 years the largest Stock Markets crashes included the Great Depression in the 1930s, the Inflation Shock in the 1970s and various Asian crashed starting in Japan in 1989 and Taiwan or Korea in the 1990s.