So this is it.
It’s times like these which separate the successful investors from the mediocre. The decisions you make now will be some of the most important in your investing career.
These are the times when you decide what your lifetime investment returns will look like. Decisions made in times of crisis are orders of magnitude more important than those made when markets are rising.
The simple (but far from easy) ability to make calm and rational decisions when markets are falling is far, far more important than any complicated portfolio construction choices you make when markets are rising. Now more than ever, not being stupid beats being smart.
Yet avoiding emotional decision-making is at its most difficult when we’re faced with the levels of uncertainty we face today.
I won’t paraphrase the following quote by Morgan Housel, because I think it deserves being read in full:
“Uncertainty shrinks your field of vision at the worst time. When the world changes in a 24-hour period it becomes hard to think more than 24 hours ahead. The year ahead is impossible to envision when assumptions you had at breakfastime were destroyed by dinnertime. The irony is that long-term thinking is most powerful when everything is falling apart. The majority of long-term results are determined by decisions made during a minority of times, and right now is one of those times. It’s a tragic moment to become short-sighted.”
To help readers navigate their decision-making in these uncertain times, I’ve split this post into two sections.
The first section looks at the reasons behind why it feels so tempting to take action immediately.
The second section is a step-by-step guide for making portfolio decisions during a crash.
Section 1: Why we feel the need for action
“There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here ever approximate what it feels like to lose a chunk of money that you used to own.”
– Fred Schwed, Where Are the Customers’ Yachts
Statistics don’t matter when the market is crashing.
I could show you every chart, table, and famous investing quote in the history of the stock market, but it won’t matter once your emotions take over.
The only thing that matters is how you choose to react.
The truth is that most of your lifetime investment returns will be determined by decisions that take place during a small minority of the time. Almost always, these will be during periods where the market’s in freefall, and nobody knows when it’s going to end. Our many years of discipline and training go out the window, and we revert to our primal cavemen instincts of herd behaviour and “fight or flight”.
This isn’t just a theory.
Pavlov, the famous psychologist who conditioned his dogs to salivate at the ring of a bell, conducted some less well-known research on those same dogs.
After the dogs been sufficiently conditioned as part of his famous experiment, Pavlov’s laboratory flooded. The dogs were being held in cages, and as the water levels rose, they became about as stressed as you can imagine. Thankfully the water receded in time to save some of them, but Pavlov noted something interesting in the surviving dogs. They all had a total reversal of their conditioned personality.
All that hard work of painstakingly conditioning his dogs to produce the desired behaviour was undone by one stressful episode.
During a market crash, we become those dogs. All the years of being told “invest for the long run”, “no risk, no reward”, and “be greedy when others are fearful”, are jettisoned in the face of the stresses brought on through the panic of a market in freefall. Not only are we losing large sums of money, but the rest of the world is panicking too. If everyone else is panicking, our natural instinct is to follow suit – evolution has taught us that in uncertain and stressful situations, it’s been safer to follow the herd than stand alone.
If there’s one thing we all have a natural, evolutionary, dislike for – it’s uncertainty. Our instincts, in the face of uncertainty, tell us to do something. If we’re uncertain about whether that rustle in the long grass is a tiger, it’s best to take action and run like hell just to be safe.
In today’s world, there’s nothing more powerful in shaping our investing behaviour than the uncertainty created by a market crash. No one really pays much attention to the markets when they’re rising because they tend to rise slowly. But when they start to fall, the losses happen in rapid succession and everyone starts paying attention very quickly.
Scary headlines dominate mainstream news outlets, ramming uncertainty down our throats. This naturally causes us to consistently check the value of our portfolio, to see how all this uncertainty is affecting us personally. Unfortunately, this is exactly the wrong thing to do.
It’s been shown over and over again that investors react disproportionately to losses. Studies on loss aversion, as it’s called, have settled on the fact that investors find losses hurt somewhere between 2x and 2.5x as much as gains.
This is a toxic mix.
The combination of skin in the game through losing our own money, our disproportionate reaction to losses, and the uncertainty of when it will end is a perfect recipe for emotional decision-making.
This inability to deal correctly with uncertainty is partly explained by our upbringing and education system. We’re not mentally prepared to think about uncertainty and risk, because we’re never taught to think in those terms. Here’s German psychologist Gerd Gigerenzer in his book Risk Savvy:
“People aren’t stupid. The problem is that our educational system has an amazing blind spot concerning risk literacy. We teach our children the mathematics of certainty—geometry and trigonometry—but not the mathematics of uncertainty, statistical thinking. And we teach our children biology but not the psychology that shapes their fears and desires. Even experts, shockingly, are not trained how to communicate risks to the public in an understandable way.”
To try and make the uncertainty go away, we’re tempted to do something – anything. We feel compelled to take action, because doing nothing feels reckless when the stakes are high. The act of doing something makes us feel like we’ve fought against the danger.
During the 1918 flu pandemic (which we’re all now acutely familiar with), face masks were found to be completely useless. Yet people still used them. This post in The Atlantic explains:
“The face mask might have offered as much protection as a rabbit’s foot. But it allowed people to feel as if they were doing something proactive, which, even a century ago, was understood to be of great psychological importance.”
Today we call the temptation to do something “action bias”, and it’s the reason football goalkeepers jump to one side when trying to save a penalty kick. Statistically speaking, the optimal strategy for goalies is to stay in the goal’s centre. But almost all goalies jump, because the feeling of not jumping and being wrong feels so much worse than standing still and being wrong – despite it being the best strategy. Jumping feels like the right thing to do, because taking action feels like you’re making an effort.
It’s the same when the market’s crashing. Taking action becomes conflated with taking control – but although it may feel good in the moment, it isn’t necessarily the right thing to do.
Section 2: What should you do?
Now we understand the reasons behind our instinct for action, let’s try and apply some rationality to that instinct.
This section goes through a step-by-step guide for making investing decisions during a market crash.
It won’t guarantee that you’ll make the absolute best decision in hindsight – nothing can guarantee that. But it should at least help mitigate the effects of prospective emotional decision-making, prevent any decisions which could lead to serious regret, and help to put this crash into context.
Here’s the guide, which I’ve designed to be followed in order:
- Go for a walk
- Revisit your investment plan
- Realise why going to cash is a bad idea
- Put things in perspective
- Understand that a crash is likely a very good thing
Now let’s begin:
1) Go for a walk.
The world is not about to end.
The crash can feel cataclysmic when we’re being bombarded by it from all sides. But as the Persian saying goes, “This too shall pass”.
Trying to stay calm and rational when headlines are screaming and markets are crashing is exhausting. It can take a lot out of all of us mentally and emotionally. Sitting and staring at headlines and red flashing numbers is really bad for us.
It’s worth remembering that we’re all long-term investors, and shouldn’t be reacting to things on a daily basis.
So take a break from the screens.
Go for a walk.
Or read a book. Any book.
Or watch a film.
Or binge-watch a few episodes of good TV.
Nobody should be tampering with their investments when they’re stressed. Remember: panic isn’t a profitable strategy.
Our first aim is to stop the cortisol pumping through your brain, and put you in a better state of mind for making decisions.
2) Revisit your investment plan.
When you’ve cleared your head and notice that the feeling of urgency has subsided, now is the time to have a look at your investment plan. Upon investing, you should have written down an investment policy statement (IPS) somewhere. If you invest through a third party (an IFA or an investment manager), they will have had to draft one with you. If you’re a DIY investor, it’s good practice to have one – even if it’s just a few lines in Excel.
If you don’t have one, that’s OK. Now is definitely not the time to start making one, but the rest of this post is still relevant for you. I have a separate post on how to create an IPS, but that’s of no use to you now. Keep going through this checklist.
For those that do have an investment plan, any half-decent plan should account for precisely these events. Every investment plan looks different, but they will all have assumed that you’ll more than likely experience more than one crash during your lifetime. Your plan should have prepared for exactly this type of event. Crashes might not be regular, and their timing might not be predictable, but they will always happen.
(For an excellent read on why bubbles/crashes will always happen, see this article.)
It’s for this reason it’s important to revisit our plan. We should all have written down in black and white what our actions should be, and it’s reassuring to see (often in our own words) what we should be doing right now.
My own investment plan tells me to simply “continue to contribute 10% to your pension every month” – and that’s good enough for me.
If your plan doesn’t specifically set out any actions to take during a crash, that’s OK. The “market crash” scenario will have been factored into your portfolio’s asset allocation. This is why you more than likely filled in a risk tolerance questionnaire before you invested, which determined your asset allocation. The purpose of the questionnaire is to ensure that your portfolio’s asset allocation is such that your portfolio doesn’t fall too far beyond what you’re willing to lose, which reduces the chances of you making hasty decisions in a moment of panic.
Whatever your plan looks like, no plan will ever say “rotate to cash when the market drops 50%”. This should be the first sign that selling out is unlikely to be the correct decision.
Just remember, your portfolio was built for this. It was built to handle corrections just like this.
3) Realise that going to cash is a bad idea
“Why don’t I just go to cash and wait this out? I can get back in when the dust settles, probably at lower prices.”
It’s an incredibly common question, and it sounds like a reasonable plan.
The problem is that nobody knows when the dust is going to settle. There’s no clear dividing line that separates the “before” and “after” – we don’t know when the crash will end or when the recovery will begin.
In reality, the dividing line is more like a sliding scale, because the market always contains at least some level of uncertainty. Levels of uncertainty range from the high-uncertainty “OH MY GOD THE MARKET IS CRASHING I NEED TO SELL IMMEDIATELY” to the lower-uncertainty “I’m really worried about [insert major geopolitical event]. Should I wait before investing?”.
The point is that there’s never any complete certainty in the market, and there’s always something to worry about which could stop you from investing.
If you sell your investments and try to time re-entering the market, picking the correct time on that sliding scale of uncertainty becomes incredibly difficult.
If you do eventually decide that the level of uncertainty has become bearable and it’s time to get back into the market, what will the market have done in the meantime?
By the time you think it’s safe enough to invest, the market will likely have already rallied in anticipation of the reduced uncertainty.
As an example, here’s a headline from the day that the market reached its absolute lowest day in 2009:
March 9, 2009: Roubini says S&P may drop to 600 as profits fall
And here are three headlines from the subsequent rapid rally over the next 6 months:
March 14, 2009: Just a sucker’s rally
December 1, 2009: 80% chance of a market crash in the next year”
The bottom is never obvious, and even a huge rally is never enough of a sign that the dust has fully settled.
One of the many problems with trying to time the market (and this is definitely a form of market timing) is that you have to be right twice.
You have to get out at the right time, and then you have to get back in again at the right time.
Selling might give you short-term relief, but getting back in is incredibly difficult.
One option is to wait till the dust has settled, but we’ve seen how difficult that can be. Another popular option is to wait for stocks to go lower before you buy.
But this comes with its own set of problems.
How much lower before you buy? How long do you wait for? What do you do if stocks bounce? How about if they bounce, then keep going higher? What if they fall 10%, you buy, then they keep falling?
As we saw in the first section, people who are selling at this moment may feel some level of comfort that they’ve stopped the bleeding. What they haven’t done is determined when they’ll get back in.
People can tie themselves in knots waiting to get back into the market while they sit on the sidelines and watch as markets continue to rise.
The problem with these binary all-in or all-out decisions is that they very often lead to regret. Regret for not having bought lower, for not having bought at all, or for selling in the first place.
The aim for making decisions during a crash is to minimise potential regret. Avoiding all-in or all-out decisions is a good way to minimise regret in the future.
Now is not the time to be making binary decisions.
In the words of Michael Batnick,
“Healthy investing, like everything else, is all about moderation. Take Obi Wan’s advice, “Only a Sith deals in absolutes.””
4) Put things in perspective
Market crashes are the price of admission for equities.
If markets didn’t crash, then stocks wouldn’t return more than bonds. It’s as simple as that. There’s no way you can avoid risk in the financial markets if you hope to beat inflation over the long-term. Stocks outperform bonds over longer cycles, but bonds provide stability when you need it.
At this point, it’s worth remembering what you own.
As a diversified equity owner, you own portions of some of the best managed, most well-capitalised businesses in the entire world.
Not all of them will be around in 50 years – some of them might not survive this crash. But over the long run, a diversified basket of equities will do exactly the same thing they’ve done since the beginning of the stock market – go up.
Charlie Munger was asked in a BBC interview how worried he was that stocks had fallen 50% after the financial crisis:
“Zero. This is the third time Warren and I have seen our holdings in Berkshire go down, top tick to bottom tick, by 50%.
I think it’s in the nature of long-term shareholding of the normal vicissitudes, of worldly outcomes, of markets, that the long-term holder has his quoted value of his stocks go down by say 50%.
In fact you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”
Warren Buffett himself has often been quoted saying that temperament is far more important than IQ when it comes to investing. He’s even said that if you do have an IQ of 160, you should just give away 30 points to somebody else. “You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. What you do need is emotional stability. You have to be able to think independently.”
Remaining un-emotional isn’t always easy, but suffering through drawdowns is par-for-the-course for equities. The chart below is one of my favourites from the fantastic JP Morgan Guide to the Markets:
Source: JP Morgan
The red dots represent the intra-year declines for each calendar year, and the grey bars represent the total return for the same year.
For example, on the far-left hand side of the chart, during 1980 the market fell to a low of -17%. But come December the return for the year was ultimately +26%.
What’s striking is the comparison between the number of red dots below the line and the number of grey bars above the line.
A large, often double-digit, decline is extremely normal for markets. The average intra-year decline in the US is 14%. And yet the market has risen in 30 of the last 40 years. If we didn’t suffer through the red dots, we wouldn’t get the grey bars.
Suffering through painful corrections is part and parcel of equity ownership. Without them, we wouldn’t be able to enjoy the benefits of compounded returns that a diversified portfolio of equities has to offer.
5) Understand that a crash is likely a very good thing
During the Great Depression, stocks fell almost 90%.
It remains by far the largest crash on record, despite having happened over 90 years ago. During the depression, an Ohio lawyer named Benjamin Roth kept a detailed diary about what he saw.
In the 1930s after the depression had mostly passed, he noted a couple of things he’d learned:
“Business will always come back. It will remain neither depressed nor exalted.”
“Depression is time of greatest profit. The investor who has liquid funds and the courage to act can lay the basis for great profits.”
Both are powerful points.
The world is not going to end, and at some point markets will recover and the next bull market will start. Nobody knows when that’ll be, but it will happen.
Now, after the markets have fallen, is a great time to take advantage.
It’s true, the market might keep falling. But even during the Great Depression, another man named Floyd Odlum made millions of dollars putting his cash into battered stocks. His motto throughout the crash never changed: “There’s a better chance to make money now than ever before.”
Even during the depression, the best investment results were earned not by the people who fled stocks for the safety of bonds and cash, but by those who stepped up and bought stocks and kept buying on the way down.
As the saying goes “Investing is the only business where when things go on sale, everyone runs out of the store.”
As with all financial decisions, personal circumstances will always dictate exactly how beneficial a stock market sell-off will be for your portfolio.
As a general rule, those who are still net savers (i.e. those who are still contributing towards a pension pot rather than withdrawing from it), and those who have time horizons of longer than 5-10 years should be cheering for these market crashes. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer falling prices.
The excellent table below shows the average returns of the S&P following different levels of drawdown, going back to 1950:
Source: Michael Batnick
Obviously average returns disguise a wide range of historic outcomes (there’s a table showing the minimum returns in the post, which I recommend reading), but the message seems pretty clear.
The larger the drawdown, the higher the long-term returns.
Also, the longer the time horizon, the more true this becomes. Looking at the 20 year return column, the difference in terminal wealth between 6.1% compounded over 20 years and 10.4% compounded over 20 years is massive.
It seems counterintuitive, but the lower the market goes, the higher future returns are likely to be.
Given that most of you reading this are likely already making monthly pension contributions, you’ll already be taking advantage of this through pound cost averaging.
Reframing market corrections as a chance to earn higher returns is a great way to improve decision-making and reduce the chances of panicking and running to cash. It might even tempt you to do the opposite, and put any spare cash to work to take advantage of the higher expected returns.
“The best opportunities come in times of maximum pessimism” – John Templeton
By now you should have:
- Cleared your head,
- Reviewed your investment plan,
- Realised that going to cash is probably a bad idea,
- Put this market crash into historical context, and
- Understood that the crash is actually a positive event if you’re a long-term investor
Now we’re ready to act.
Step 1: What did your investment plan say?
Most plans will have a rebalancing rule somewhere in there, which states under what circumstances your portfolio should be rebalanced. During a market crash, it’s almost guaranteed that your holdings will diverge away from their neutral weights as stocks fall and bonds (probably) rise. If it says to rebalance when asset classes move X% away from their neutral weighting, then now is likely a good chance to rebalance. You’ll likely end up selling bonds for a high price and buying stocks for a low price – always a good trade.
This also has the benefit of you doing something, which feels good (as we’ve seen).
Step 2: Consider your overall asset allocation.
Do you have any extra cash that’s been sitting around which has been waiting for an opportunity to get invested?
If so, now would be a great time to consider putting it to work.
Step 3: Now you’ve rebalanced and put any extra cash to work. Or your investment plan doesn’t recommend any specific actions (or you don’t have an IPS), and you don’t have any extra cash to invest.
This is the important bit.
I repeat: Do nothing.
Thanks to what we saw in the first section, we know that it will feel uncomfortable. More importantly we now understand why.
Doing nothing is an active decision – and very often in investing, it’s the best one.
If you’ve followed all the steps we’ve just been through, then the answer to the “What should you do?” question is:
Go for a walk.
Or read a book. Any book.
Or watch a film.
Or binge-watch a few episodes of good TV.
Nobody should be tampering with their investments when they’re stressed. Remember: panic isn’t a profitable strategy.
Does that sound familiar?
As the late Jack Bogle said:
“My rule — and it’s good only about 99% of the time, so I have to be careful here — when these crises come along, the best rule you can possible follow is not “Don’t stand there, do something,” but “Don’t do something, stand there!””
Hopefully by going through this post – particularly the second section – you’ve managed to tune out the noise and are in a better place to start making investment decisions.
We’ve examined the reasons why market crashes make us feel compelled to take action, and worked through a framework of improving our decision-making. Along the way, we’ve revisited our investment plan, understood the significant drawbacks of going to cash, reframed the market crash into something that’s to be expected, and seen that it very likely puts us in a better position than we were before.
Following all these steps is by no means a guaranteed way to maximise returns, but it at least reduces the chances of making hasty, emotional decisions which you might later regret.
I realise that this is likely to be a stressful time for many people, so feel free to reach out to me here if you’ve got any questions. I might not be able to give you personalised financial advice, but I can at least act as the voice of reason, and hopefully help keep those fear-mongering CNBC talking heads at bay.