- Gaining the Courage to Invest
- Stock Market Psychology
- Invest Safely
- Diversity is Good
- Overcoming Our Financial Trauma
- How to Make Money from Stocks
- What if the stock price goes down?
- Smart Investors Embrace Stock Market Crashes
- Buying Stocks On Sale
- When is the right time to buy stocks?
- When should I sell my stocks?
Gaining the Courage to Invest
As an accounting student, I was inspired by the movie The Big Short, which tells the true story of savvy financial insiders who capitalized on a disaster no one saw coming. It made the financial community look like sheep running off a cliff. Soon I was “shorting” the market like my heroes, betting against the financial system I distrusted. Since then I’ve learned that cautious optimism makes a much better investment strategy. I’m not smart enough to predict the next crash, nor do I have to be.
It’s been hard to ignore the constant danger signs preached in the media over the past 20 years. Because of that, I spent most of my adult life waiting for the market to crash before I would start buying stocks. I had an irrational opinion that the current growth rate was unstable, even though 10% annual growth is the historical norm! As years went by, and the stock market rallied over and over, I realized I had wasted a golden opportunity to build wealth. That was a painful lesson, but it made me a better long-term investor. I hope you don’t have to learn that lesson the hard way.
In this article, you will learn how an expert investment strategy works, and how it can help you overcome future stock market crashes.
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Stock Market Psychology
The stock market runs on a massive combination of flawed opinions about the future. The price of a stock reflects the market’s current prediction of future earnings. As expectations swing back and forth, they sometimes become unrealistic. The financial media love to provoke hysteria. It’s entertaining news, but it’s not helpful for investing. Later you’ll see why overreacting can be costly.
A seat belt can’t completely protect you from a car crash. Similarly, no investment is risk-free. Even cash can lose value from inflation or theft. Although I think everyone should invest in stocks, it can be dangerous for beginners. Don’t take big risks in pursuit of quick wealth. Keep it simple and don’t invest until you understand what you’re buying. Essentially, a stock is just a claim to own a fraction of a business, so think of yourself as a potential business owner.
Diversity is Good
It’s also important not to invest too heavily in one company. You might think a company like Amazon will dominate forever, but it only takes one new law or scandal to cause a severe drop in value. It’s safer to diversify your investments, which is easier than it sounds. When I talk about investing in “stocks”, I generally mean buying an index fund, or ETF, composed of many stocks. Although there are many alternatives, I’ll use the S&P 500 index in my examples. It’s the best option for most people, and it’s the index I use for my retirement funds.
Note: If you want to buy a low-fee S&P 500 index from Vanguard, search for the symbol “VOO” in your brokerage app.
Overcoming Our Financial Trauma
Most Americans are familiar with the financial hardship of the 2000s. Therefore, I thought it would be great to go back in time to test my investment strategy in one of the worst economic times imaginable. Let’s have some fun!
As an example, imagine you started investing in the S&P 500 index right before the end of a market bubble (eg. dot-com bubble of 2000). If you’re like the average person, you had less than a year’s salary saved up. After the market crashed 50%, it got cut in half. You might have thought, “Wow! That’s just my luck. The stock market is clearly not for me. I think I’ll leave it to the professionals from now on.” That would be a huge mistake if you still have years left to work, earn, and save.
Imagine instead you were very disciplined, and you invested the same amount every month starting April 1, 2000 until February 1, 2021. Now let’s look at what happens over the next 20 years.
Take note of how much time is spent below the zero percent level. It’s surprisingly short considering how severe the economic downturn was. Your investments did poorly in the first few years, but by year five they went positive. Hooray! Things looked great until 2008 when another financial crisis hit, and you went negative again.
You’d probably feel hopeless at this point, but look at what happens next. The market hit a bottom and, guess what… recovered again. Since then, the market climbed to new highs as the economy recovered. By 2021, you would have $2.70 for every dollar you invested. You never hear about that on the news!
How to Make Money from Stocks
As a stockholder, your business creates value for you by earning profits. They can do two things with those profits:
- Payout cash dividends to you
- Use the money to help grow the business
Growth will cause the stock price to increase. When the stock price rises, your investment gains value, and you can sell it for a profit. Stocks are like any inventory. Your breakeven point, or cost basis, is the price you paid.
What if the stock price goes down?
Your stocks can lose value, just like when you drive a new car off the lot. Nothing has changed except the price other people are willing to pay for it. Broad market declines usually don’t last too long though. This is evident from the picture above. The two major crashes in 2000 and 2008 were relatively short-lived, and the market returned to normal. Here are a few reasons why the stock market might recover quickly:
- Businesses continue to create value and grow
- Governments provide economic stimulus
- Dividends don’t always fall along with stock prices
- Life goes on
Smart Investors Embrace Stock Market Crashes
Investing is about building wealth, so why would one hope for a market crash?
Buying Stocks On Sale
Downturns aren’t all bad. Sometimes it’s a great opportunity to reduce your cost basis, so you can earn more down the road. Think of it as buying stocks on sale. When you’re a buyer, you want the lowest price possible. Let’s revisit our previous strategy and see how the average cost basis changed over time.
Take a look at the first few years. The stock price (in blue) decreases, then increases back to its original level. That doesn’t sound great, but since we were making monthly contributions, our breakeven point (in red) followed the market as it went down. When prices returned to prior levels, the overall market was no better off, but we made a profit!
When is the right time to buy stocks?
Short Answer: Often
Guessing the right time to buy stocks is what financial professionals call “timing the market”. Most people can’t predict the future, even when that’s their job. Timing the market is like gambling. Unless you have some legitimate knowledge of the future, it’s better to form a strategy to deal with uncertainty. A big problem with waiting for crashes is you never know how long you might have to wait. You might waste ten years missing out on huge gains as I did!
As long as you invest regularly, it’s always a good time to buy stocks. To prove it, let’s look at the difference between buying stocks and saving your money in a bank account over the same 20 year period.
Although cash is a safe store of value, it lacks the huge growth opportunities stocks offer. The effect of compound interest provides exponential growth for stocks. The earlier you invest, the greater this difference will be.
When should I sell my stocks?
Short Answer: Retirement
You might be tempted to cash out your profits by selling your stock. That’s the gambler’s strategy of quitting while you’re ahead. But remember, you’re not gambling. You’re investing, and that requires a different strategy.
Ask yourself, “Am I attempting to predict future market fluctuations?”. If the answer is yes, you should think twice about selling your stock. You should always strive to put your money in its most beneficial use. Stocks grow more often than they decline. If you avoid selling until retirement, you’ll maximize your money’s opportunity to grow.
Stock sales can be taxable. Any tax you pay is money that could have been invested. A financial advisor can help you optimize your investment strategy for taxes. It might not seem important now, but you’ll be dealing with big numbers at the end!
Once you reach retirement, you can sell small portions of your stock holdings to fund your living expenses. 4% is widely considered a safe annual withdrawal rate. Smart retirement planning will ensure your investment income covers your cost of living for the rest of your life.
The best time to buy stocks is now! It’s not when you invest that matters. Rather, it’s how often you do it. The US stock market has a good history of surviving bad times. It may take years to recover, but eventually, prices have surpassed the level they were before a crash. Luckily, there is a simple way to use this pattern to your advantage.
A great strategy is to budget a healthy percentage of your monthly income and consistently invest in a broad stock market index such as the S&P 500 (credit to Warren Buffett). It’s so simple, but how many people have the discipline to put it into practice?
I hope this article helps you understand the risks and rewards of stock investing. It’s always important to consider your appetite for risk before you make any big financial decisions. A young person can afford to wait a few years for a market recovery, so I use the strategy outlined in this article to pursue my goals of financial independence and early retirement. If you found this article useful, please share the bliss by clicking below!