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WINTER IS COMING . . . BUT WHEN?
These Seven Facts Will Free You from the Fear of Corrections and Crashes
The key to making money in equities is not to get scared out of them.
—PETER LYNCH, who returned 29% a year as a famed fund manager at Fidelity Investments
Power. The ability to shape and influence life’s circumstances. The fuel to produce extraordinary results. Where does it comes from? What makes a person powerful? What creates power in your own life?
When humans lived as hunter-gatherers, we had no power. We were at the mercy of nature. We could be ripped apart by vicious predators or destroyed by brutal weather whenever we ventured into the wild to hunt or scavenge for food. And food wasn’t always there. But gradually, over many thousands of years, we developed an invaluable skill: we learned to recognize—and utilize—patterns.
Most important, we observed the patterns of the seasons. And we learned to take advantage of them by planting crops at the right time. This capability moved us from scarcity to abundance—to a way of life in which communities and eventually cities and civilizations could flourish. Our gift for pattern recognition literally changed the course of human history.
Along the way, we also learned a vitally important lesson: we’re not rewarded when we do the right thing at the wrong time. If you plant in winter, you’ll get nothing but pain, no matter how hard you work. To survive and thrive, you and I have to do the right thing at the right time.
Our capacity for pattern recognition is also the number one skill that can empower us to achieve financial prosperity. Once you recognize the patterns in the financial markets, you can adapt to them, utilize them, and profit from them. This chapter will give you that power.
The majority of investors fail to take full advantage of the incredible power of compounding—the multiplying power of growth times growth.
Before we get to the heart of this chapter, let’s just take two minutes to discuss a fundamental concept that I’m sure you already know, but one that we need to utilize and maximize in order to build lasting wealth.
The first pattern we need to recognize is that there’s a miraculously powerful way to build wealth that’s available to all of us—one that Warren Buffett has harnessed to amass a fortune that now stands at $65 billion. What’s his secret? It’s simple, says Buffett: “My wealth has come from a combination of living in America, some lucky genes, and compound interest.” I can’t vouch for your genes, though I’m guessing they’re pretty good! What I do know for sure is that compounding is a force that can catapult you to a life of total financial freedom. Of course, we all know about compounding, but it’s worth reminding ourselves just how impactful it can be when we truly understand how to make it work for us. In fact, our ability to recognize and utilize the power of compounding is the life-changing equivalent of our ancestors’ discovery that they could produce bountiful harvests by planting crops at the right time!
Let’s illustrate the tremendous impact of compounding with just one simple but mind-blowing example. Two friends, Joe and Bob, decide to invest $300 a month. Joe gets started at age 19, keeps going for eight years, and then stops adding to this pot at age 27. In all, he’s saved a total of $28,800.
Joe’s money then compounds at a rate of 10% a year (which is roughly the historic return of the US stock market over the last century). By the time he retires at 65, how much does he have? The answer: $1,863,287. In other words, that modest investment of $28,800 has grown to nearly two million bucks! Pretty stunning, huh?
His friend Bob gets off to a slower start. He begins investing exactly the same amount—$300 a month—but doesn’t get started until age 27. Still, he’s a disciplined guy, and he keeps investing $300 every month until he’s 65—a period of 39 years. His money also compounds at 10% a year. The result? When he retires at 65, he’s sitting on a nest egg of $1,589,733.
Let’s think about this for a moment. Bob invested a total of $140,000, almost five times more than the $28,800 that Joe invested. Yet Joe has ended up with an extra $273,554. That’s right: Joe ends up richer than Bob, despite the fact that he never invested a dime after the age of 27!
What explains Joe’s incredible success? Simple. By starting earlier, the compound interest he earns on his investment adds more value to his account than he could ever add on his own. By the time he reaches age 53, the compound interest on his account adds over $60,000 per year to his balance. By the time he’s 60, his account is growing by more than $100,000 per year! All without adding another dime. Bob’s total return on the money he invested is 1,032%, whereas Joe’s return is a spectacular 6,370%.
Now let’s imagine for a moment that Joe didn’t stop investing at age 27. Instead, like Bob, he kept adding $300 a month until he was 65. The result: he ends up with a nest egg of $3,453,020! In other words, he has $1.86 million more than Bob because he started investing 8 years earlier.
That’s the awesome power of compounding. Over time this force can turn a modest sum of money into a massive fortune.
But you know what’s amazing? Most people never take full advantage of this secret that’s lying in full view, this wealth-building miracle that’s sitting there right in front of their eyes. Instead, they continue to believe that they can earn their way to riches. It’s a common misperception—this belief that, if your earned income is big enough, you’ll become financially free.
The truth is, it’s not that simple. We’ve all read stories about movie stars, musicians, and athletes who earned more money than God yet ended up broke because they didn’t know how to invest that income. After a series of lousy investments, the rapper 50 Cent recently declared bankruptcy—despite having had a net worth estimated at $155 million. Actress Kim Basinger, at the height of her popularity, was pulling in more than $10 million per film. And yet she also ended up bankrupt. Even the King of Pop, Michael Jackson, who reportedly signed a recording contract worth almost $1 billion and sold more than 750 million records, supposedly owed more than $300 million upon his death in 2009.
The lesson? You’re never going to earn your way to financial freedom. The real route to riches is to set aside a portion of your money and invest it, so that it compounds over many years. That’s how you become wealthy while you sleep. That’s how you make money your slave instead of being a slave to money. That’s how you achieve true financial freedom.
By now, you’re probably thinking to yourself, “Yeah, but how much money do I have to set aside in order to reach my financial goals?” That’s a great question! As mentioned, to help you answer it, we’ve developed a mobile app that you can use to figure out exactly what you’ll need to save and invest. It’s available at www.unshakeable.com.
Everyone’s situation is unique, so I’d recommend sitting down with a financial advisor to discuss your specific goals and how to reach them. But I want to warn you, most advisors grossly underestimate how much money you’re likely to need to be financially secure, independent, or free. Some say you should have a nest egg that’s ten times what you earn currently. Others, who are a bit more realistic, say you’ll need fifteen times. In other words, if you’re making $100,000, you’ll need $1.5 million. If you’re making $200,000, you’ll need $3 million. You get the idea.
In reality, the number you should really aim for is 20 times your income. So, if you currently earn $100,000, you’ll need $2 million. It may sound like a lot, but remember that our friend Joe got there with a mere $28,000, and my bet is you’ll have much more than this to invest over the coming years.
You can read about this in greater detail in Money: Master the Game, which has an entire section on this subject. As I explain there, it’s easy to get overwhelmed when you look at a huge number like this. But it’s less intimidating when you start with an easier target. For example, maybe your first goal is financial security—not total independence. How would you feel if you could cover the cost of your mortgage, food, utilities, transportation, and insurance, all without ever working again? Pretty great, right? The good news is, this number is usually 40% less than ultimate financial independence, where everything you need is paid for, and thus you can hit it quicker. Once you hit that target, you’ll have built up so much momentum that the bigger number won’t feel like such a stretch.
But how are you going to get there? First, you’ve got to save and invest—become an owner, not just a consumer. Pay yourself first by taking a percentage of your income and having it deducted automatically from your paycheck or bank account. This will build your Freedom Fund: the source of lifetime income that will allow you to never have to work again. My guess is you’re already doing this. But maybe it’s time to give yourself a raise: increase what you save from 10% of your income to 15%, or from 15% to 20%.
For some people, 10% may seem impossible right now. Maybe you’re at a stage in your life when you have student loans or major obligations to your family or a business. No matter what your situation, you have to take the first step and get underway. There’s a proven method called “Save More Tomorrow,” which I describe in detail in Chapter 1.3 of Money: Master the Game. You start by saving just 3% and gradually raise this to 15% or 20% over time.
Now that you’ve saved it, where are you going to invest for the maximum returns so that you reach your target faster?
The single best place to compound money over many years is in the stock market. In chapter 6, we’ll discuss the importance of putting together a diversified portfolio that includes other assets. But for now, we’re going to focus on the stock market. Why? Because this is incredibly fertile land! Like our ancestors, we need to plant our seeds where we can reap the greatest harvest.
WHERE SHOULD I PUT MY MONEY?
As you and I both know, the stock market has made millions of people rich. Over the last 200 years, despite many ups and downs, it’s been the best place for the long-term investor to build wealth.I But you need to understand the market’s patterns. You need to understand its seasons. That’s what this chapter is all about.
What’s the biggest financial question on all of our minds today? In my experience, we’re all searching for answers to pretty much the same question: “Where should I put my money?”
This question has become more urgent lately because all of the answers seem unappealing. In an era of compressed interest rates, you earn nothing when you keep your cash in a savings account. If you buy a high-quality bond (for example, if you lend money to the Swiss or Japanese governments), you’ll earn less than nothing! There’s a joke going around that traditionally safe investments like these now offer “return-free risks” instead of “risk-free returns!” What about stocks? Hundreds of billions of dollars from all over the globe have poured into the US stock market, which many people regard as a relatively safe haven in an uncertain world. But that’s created even greater uncertainty because US stock prices—and valuations—have soared over the past seven and a half years, fueling fears that the market is bound to plunge. Even people who’ve done well in this rising market are worried that the whole thing could fold, that there’s nothing propping it up except the central banks and their crazy policies!
So what should you do? Prepare for a stock market meltdown by selling everything and running to the hills? Keep all of your money in cash (earning zilch) and wait till the market plummets so you can buy in at lower prices? But how long can you wait? What about all those unfortunate souls who’ve already waited for years, missing the entire bull market? Or should you stay in the market, sit tight, close your eyes, and assume the “brace position” as you prepare for impact? I told you: none of these options sounds that enticing!
As you know, humans have a tough time handling uncertainty. So how are we supposed to make intelligent decisions in this environment where everything seems uncertain? What can we do if we have no idea when the market will plunge—when the financial equivalent of winter will finally arrive?
But I’ve got news for you: we do know when winter will arrive. How? Because when we look back at the stock market over an entire century, we discover this extraordinary fact: financial winter comes, on average, every year.
Once you start to recognize long-term patterns like this, you can utilize them. Even better, your fear of uncertainty melts away because you see that important aspects of the financial markets are much more predictable than you’d ever realized.
So, we’re going to walk you through seven facts that will show you how the markets work. You’ll learn that certain patterns repeat again and again. And you’ll learn to base your decisions on an understanding of those proven patterns—just like our ancestors who discovered that planting seeds in spring was a winning strategy. Of course, nothing is ever entirely certain in farming, financial markets, or life! Some winters arrive sooner, some later; some are severe, some mild. But when you stick with an effective approach over many years, your probability of success increases massively. What separates the money masters from the crowd is this ability to find a winning strategy and stick with it, so the odds are always strongly in their favor.
Once you understand the seven indisputable facts we’re about to explain, you’ll know how the financial seasons work. You’ll know the rules of the game—the principles on which it’s based. This will give you an enormous edge, since even many experienced and sophisticated investors don’t know these facts. Armed with this knowledge, you can get in the game, stay in it, and win. Best of all, these facts will free you from all of the fear and anxiety that dominate most people’s financial lives. That’s why we call them Freedom Facts.
And let me tell you, the ability to invest without fear is critically important. Why? Because so many people are so paralyzed by fear that they can barely bring themselves to dip their toes in the water. They’re terrified that the stock market will crash and wash away all of their hard-earned savings. They’re terrified that stocks will nosedive right after they invest. They’re terrified that they’ll get hurt because they don’t know what they’re doing. But as you’ll soon discover, all those fears will quickly fall away once you understand the pattern of facts that we’re going to reveal over the next few pages.
But before we get started, let me quickly explain some investment jargon. When any market falls by at least 10% from its peak, it’s called a correction—a peculiarly bland and neutral term for an experience that most people relish about as much as dental surgery! When a market falls by at least 20% from its peak, it’s called a bear market.
We’ll begin by sharing some surprising Freedom Facts about corrections. Then we’ll turn our attention to bear markets. Finally, we’ll explain the most important fact of all: the biggest danger isn’t a correction or a bear market, it’s being out of the market.
Freedom Fact 1: On Average, Corrections Have Occurred About Once a Year Since 1900
Have you ever listened to the pundits on CNBC or MSNBC talking about the stock market? Isn’t it amazing how dramatic they can make it sound? They love talking about volatility and turmoil because fear draws you into their programming. They’re constantly analyzing minicrises that prognosticators predict could trigger market mayhem. The crisis in question might be unrest in the Middle East, slumping oil prices, the downgrading of US debt, a “fiscal cliff,” a budget standoff, Brexit, a China slowdown, or whatever else they can milk for excitement. And by the way, if you don’t understand these things, don’t worry: most of these experts don’t either!
I don’t blame them for peddling drama. It’s their job. But between you and me, none of this is really that exciting. A lot of it is just hyped up to stop you from reaching for your remote control. The trouble is, all this babble, all this drama, all this emotion can make it hard for us to think clearly. When we hear these “experts” speaking in grave voices about the possibility of a correction or a crash or a crisis, it’s easy to become anxious because it sounds like the sky is about to fall. It might make for good TV, but the last thing you and I want is to make fear-based financial decisions. So we have to remove as much emotion as possible from this game.
Instead of getting distracted by all this noise, it helps to focus on a few key facts that truly matter. For example, on average, there’s been a market correction every year since 1900. When I first heard this, I was floored. Just think about it: if you’re 50 years old today and have a life expectancy of 85, you can expect to live through another 35 corrections. To put it another way, you’ll experience the same number of corrections as birthdays!
Why does this matter? Because it shows you that corrections are just a routine part of the game. Instead of living in fear of them, you and I have to accept them as regular occurrences—like spring, summer, fall, and winter. And you know what else? Historically, the average correction has lasted only 54 days—less than two months! In other words, most corrections are over almost before you know it. Not that scary, right?
Still, when you’re in the midst of a correction, you might find yourself becoming emotional and wanting to sell because you’re anxious to avert the possibility of more pain. You’re certainly not alone. These widespread emotions create a crisis mentality. But it’s important to note that, in the average correction over the last 100 years, the market has fallen only 13.5%. From 1980 through the end of 2015, the average drop was 14.2%.
It can feel pretty uncomfortable when your assets are taking that kind of a hit—and the uncertainty leads many people to make big mistakes. But here’s what you have to remember: if you hold tight, it’s highly likely that the storm will soon pass.
Freedom Fact 2: Less Than 20% of All Corrections Turn Into a Bear Market
When the market starts tumbling—especially when it’s down more than 10%—many people hit their pain threshold and start to sell because they’re scared that this drop could turn into a death spiral. Aren’t they just being sensible and prudent? Actually, not so much. It turns out that fewer than one in five corrections escalate to the point where they become a bear market. To put it another way, 80% of corrections don’t turn into bear markets.
If you panic and move into cash during a correction, you may well be doing so right before the market rebounds. Once you understand that the vast majority of corrections aren’t that bad, it’s easier to keep calm and resist the temptation to hit the eject button at the first sign of turbulence.
Freedom Fact 3: Nobody Can Predict Consistently Whether the Market Will Rise or Fall
The media perpetuates a myth that, if you’re smart enough, you can predict the market’s moves and avoid its downdrafts. The financial industry sells the same fantasy: economists and “market strategists” from big investment banks confidently predict where the S&P 500 will stand at the end of the year, as if they have a crystal ball or (equally unlikely) superior insight.
Newsletter writers also love to act like Nostradamus and warn you of the “coming crash,” hoping you’ll feel compelled to subscribe to their services so you can avoid this fate. Many of them make the same dire predictions every year until they’re occasionally right, as anyone would be. After all, even a man with a broken watch can tell you the correct time twice a day. These self-proclaimed seers then use that “accurate” prediction to market themselves as the next great market timer. Unless you’re wise to this trick, it’s easy to fall for it.
Some of these folks may actually believe in their own powers of prediction; others are just slick salesmen. So take your pick: Are they idiots or liars? I couldn’t possibly say! But I’ll tell you this: if you’re ever tempted to take them seriously, just remind yourself of this classic remark from the physicist Niels Bohr: “Prediction is very difficult, especially about the future.” I’m not sure how you feel about the tooth fairy or the Easter Bunny. But when it comes to our finances, it’s best to face facts. And the fact is, nobody can consistently predict whether markets will rise or fall. It’s delusional to think that you or I could successfully “time the market” by jumping in and out at the right moments.
If you’re not convinced, here’s what two of the wisest masters of the financial world think of market timing and the challenge of predicting market movements. Jack Bogle, the founder of Vanguard, which has more than $3 trillion in assets under management, has said, “Sure, it would be great to get out of the stock market at the high and back in at the low, but in 65 years in the business, I not only have never met anybody that knew how to do it, I’ve never met anybody who had met anybody that knew how to do it.” And Warren Buffett has said, “The only value of stock forecasters is to make fortune-tellers look good.” Still, I have to confess, it’s fun to watch all these market pundits, commentators, and economists make fools of themselves by trying to pinpoint a correction. Look at the chart on the following page, and you’ll see what I mean. One of my favorite examples is economist Dr. Nouriel Roubini, who predicted (wrongly) that there’d be a “significant” stock market correction in 2013. Roubini, one of the best-known forecasters of our time, was nicknamed “Dr. Doom” because of his many prophecies of disaster. He successfully predicted the 2008 market meltdown. Unfortunately, he also warned of a recession in 2004 (wrongly), 2005 (wrongly), 2006 (wrongly), and 2007 (wrongly).
In my experience, market seers like Roubini are clever and articulate, and their arguments are often compelling. But they thrive by scaring the living daylights out of you—and they’ve been wrong again and again and again. Sometimes they get it right. But if you listen to all of their scary warnings, you’ll end up hiding under your bed, clutching a tin box containing your life savings. And let me tell you a secret: historically, that’s not been a winning strategy for long-term financial success.
Merchants of Doom
If you’d like, take a moment and look at these 33 failed predictions by self-appointed market forecasters. Each of the numbers below corresponds to the date of the prediction in the graph. The common pattern is they’re all predicting that the market will go down when it’s actually going up.
“Market Correction Ahead,” Bert Dohmen, Dohmen Capital Research Group, March 7, 2012.
“Stocks Flirt with Correction,” Ben Rooney, CNN Money, June 1, 2012.
“10% Market Correction Looms: Dig in or Bail Out?,” Matt Krantz, USA Today, June 5, 2012.
“A significant equity-price correction could, in fact, be the force that in 2013 tips the US economy into outright contraction,” Nouriel Roubini, Roubini Global Economics, July 20, 2012.
“Prepare for Stock Market Crash 2013,” Jonathan Yates, moneymorning.com, June 23, 2012.
“Dr. Doom 2013 Prediction: Roubini Says Worse Global Economic Turmoil Approaching; Five Factors to Blame,” Kukil Bora, International Business Times, July 24, 2012.
“Watch out for a Correction—or Worse,” Mark Hulbert, MarketWatch, August 8, 2012.
“We think we are set up for an 8–10% correction in the month of September,” MaryAnn Bartels, Bank of America–Merrill Lynch, August 22, 2012.
“It’s Coming: One Pro Sees Big Stock Selloff in 10 Days,” John Melloy, CNBC, September 4, 2012.
“Warning: Stock Correction May Be Coming,” Hibah Yousuf, CNN Money, October 4, 2012.
“I’m going around town telling my hedge fund clients that the US economy is headed into recession,” Michael Belkin, Belkin Limited, October 15, 2012.
“Fiscal Cliff Blues May Lead to Correction,” Caroline Valetkevitch and Ryan Vlastelica, Reuters, November 9, 2012.
“Why a Severe Stock Market Correction’s Imminent,” Mitchell Clark, Lombardi Financial, November 14, 2012.
“By summer, we get another crash,” Harry Dent, Dent Research, January 8, 2013.
“A Stock Market Correction May Have Begun,” Rick Newman, U.S. News & World Report, February 21, 2013.
“Sluggish Economy May Signal Correction,” Maureen Farrell, CNN Money, February 28, 2013.
“I think a correction is coming,” Byron Wien, Blackstone, April 4, 2013.
“Market’s Long Overdue Correction Seems to Be Starting,” Jonathan Castle, Paragon Wealth Strategies, April 8, 2013.
“5 Warning Signs of a Coming Market Correction,” Dawn Bennett, Bennett Group Financial Services, April 16, 2013.
“Stock Market Warning Signs Becoming Ominous,” Sy Harding, StreetSmartReport.com, April 22, 2013.
“Don’t buy—sell risk assets,” Bill Gross, PIMCO, May 2, 2013.
“This may not be the time to sprint away from risk, but it is the time to walk away,” Mohamed El-Erian, PIMCO, May 22, 2013.
“We’re due for a correction soon,” Byron Wien, Blackstone, June 3, 2013.
“Doomsday poll: 87% Risk of Stock Crash by Year-End,” Paul Farrell, MarketWatch, June 5, 2013.
“Stock Shrink: Market Heading for Severe Correction,” Adam Shell, USA Today, June 15, 2013.
“Don’t Be Complacent—A Market Correction Is On Its Way,” Sasha Cekerevac, Investment Contrarians, July 12, 2013.
“For Two Months, My Models Have Told Me That July 19th Would Be the Start of a Big Stock Market Sell-Off,” Jeff Saut, raymondjames.com, July 18, 2013.
“Signs of a Market Correction Ahead,” John Kimelman, Barron’s, August 13, 2013.
“Correction Watch: How Soon? How Bad? How to Prepare?,” Kevin Cook, Zacks.com, August 23, 2013.
“I Think There’s a Decent Chance Stocks Will Crash,” Henry Blodget, Business Insider, September 26, 2013.
“5 Reasons to Expect a Correction,” Jeff Reeves, MarketWatch, November 18, 2013.
“Time to Brace for a 20% Correction,” Richard Rescigno, Barron’s, December 14, 2013.
“Blackstone’s Wien: Stock Market Poised for 10% Correction,” Dan Weil, Moneynews.com, January 16, 2014.
Freedom Fact 4: The Stock Market Rises over Time Despite Many Short-Term Setbacks
The S&P 500 index experienced an average intra-year decline of 14.2% from 1980 through the end of 2015. In other words, these market drops were remarkably regular occurrences over 36 years. Once again, nothing to be scared of—just a matter of winter putting in its usual seasonal appearance. But you know what really blows my mind? As you can see in the chart below, the market ended up achieving a positive return in 27 of those 36 years. That’s 75% of the time!
Despite a 14.2% average drop within each year, the US market ended up with a positive return in 27 of the last 36 years.
Why is this so important? Because it reminds us that the market generally rises over the long run—even though we hit a huge number of potholes along the way. You know as well as I do that the world had its fair share of problems over those 36 years, including two Gulf wars, 9/11, the conflicts in Iraq and Afghanistan, and the worst financial crisis since the Great Depression. Even so, the market ultimately rose in all but 9 of those years.
What does this mean in practical terms? It means that you and I should always remember that the long-term trajectory is likely to be good, even when the short-term news is dismal and the market is getting smacked. We don’t need to get bogged down in economic theory here. But it’s worth mentioning that the US stock market typically rises over time because the economy expands as American companies become more profitable, as American workers become more efficient and productive, as the population grows, and as technology drives new innovation.
I’m not saying that every company—or every individual stock—will do well over time. As you and I both know, the business world is a Darwinian jungle! Some companies will die, and some stocks will fall to zero. But one big advantage of owning an index fund that tracks a basket of stocks such as the S&P 500 is that the weaker companies intermittently get culled and replaced by stronger ones. It’s survival of the fittest in action! The great thing is that you benefit from these upgrades in the quality of the companies in the index. How? Well, as a shareholder of an index fund, you own part of the future cash flows of the companies in that index. This means that the American economy is making you money even while you sleep!
But what if America’s economic future is lousy? It’s a fair question. We all know there are serious challenges, whether it’s the threat of terrorism, global warming, or Social Security liabilities. Even so, this is an incredibly dynamic and resilient economy with some powerful trends driving its future growth. In his 2015 annual report, Warren Buffett addressed this subject at length, explaining how population growth and extraordinary gains in productivity will create an enormous increase in wealth for the next generation of Americans. “This all-powerful trend is certain to continue: America’s economic magic remains alive and well,” he wrote. “For 240 years, it’s been a terrible mistake to bet against America, and now is no time to start.” Freedom Fact 5: Historically, Bear Markets Have Happened Every Three to Five Years
I hope you’re starting to see why it’s a good idea to be a long-term investor in the stock market and not merely a short-term trader. And I hope it’s now equally obvious that you don’t need to live in fear of corrections. Just to recap for a moment: you know now that corrections happen regularly; that nobody can predict when they’ll happen; and that the market usually rebounds quickly, resuming its general upward trajectory. Any fear you once felt should turn to power. Believe me, these facts hit me like a revelation: once I understood them, all of my concerns about corrections melted away. Here was factual proof that the snake was nothing but an inert rope!
But what about bear markets? Shouldn’t we be terrified of them? Actually, no. Here again, we need to understand a few key facts so we can act on the basis of knowledge, not emotion.
The first fact you need to know is that there were 34 bear markets in the 115 years between 1900 and 2015. In other words, on average, they happened nearly once every three years. More recently, bear markets have occurred slightly less often: in the 70 years since 1946, there have been 14 of them. That’s a rate of one bear market every five years. So, depending on when we start counting, it’s fair to say that bear markets have historically happened every three to five years. At that rate, if you’re 50 years old, you could easily live through another eight or ten bear markets!
You and I both know that the future will not be an exact replica of the past. Still, it’s useful to study the past to gain a broad sense of these recurring patterns. As the saying goes, “History doesn’t repeat itself, but it rhymes.” So, what do we learn from more than a century of financial history? We learn that bear markets are likely to continue happening every few years, whether we like it or not. As I said before, winter is coming. So, we’d better get used to it—and prepare.
How bad does it get when the market really crashes? Well, historically, the S&P 500 has dropped by an average of 33% during bear markets. In more than a third of bear markets, the index plunged by more than 40%. I’m not going to sugarcoat this. If you’re someone who panics, sells everything in the midst of this mayhem, and locks in a loss of more than 40%, you’re going to feel like a grizzly bear mauled you for real. Even if you have the knowledge and fortitude not to sell, you’ll likely find that bear markets are a gut-wrenching experience.
Even an old warhorse like my buddy Jack Bogle admits that they’re no walk in the park. “How do I feel when the market goes down 50%?” he asks rhetorically. “Honestly, I feel miserable. I get knots in my stomach. So what do I do? I get out a couple of my books on ‘staying the course’ and reread them!” Sadly, many advisors fall victim to the same fear and hide under their desks during these tumultuous times. Peter Mallouk told me that the ongoing communication during these storms is what sets Creative Planning apart. His company is the proverbial lighthouse, broadcasting the message “Stay the course!” But here’s what you need to know: bear markets don’t last. If you look at the chart on the next page, you’ll see what happened in the 14 bear markets we’ve experienced in the United States over the last 70 years. They varied widely in duration, from a month and a half (45 days) to nearly 2 years (694 days). On average, they lasted about a year.
When you’re in the midst of a bear market, you’ll notice that most of the people around you become consumed with pessimism. They start to believe that the market will never rise again, that their losses will only deepen, that winter will last forever. But remember: winter never lasts! Spring always follows.
The most successful investors take advantage of all that fear and gloom, using these tumultuous periods to invest more money at bargain prices. Sir John Templeton, one of the greatest investors of the last century, talked to me at length about this in several interviews I did with him before he passed away in 2008. Templeton, who made a fortune buying cheap stocks in the midst of World War II, explained: “The best opportunities come in times of maximum pessimism.”
Freedom Fact 6: Bear Markets Become Bull Markets, and Pessimism Becomes Optimism
Do you remember how fragile the world seemed in 2008 when banks were collapsing and the stock market was in free fall? When you pictured the future, did it seem dark and dangerous? Or did it seem like the good times were just around the corner and the party was about to begin?
As you can see from the chart on the next page, the market finally hit rock bottom on March 9, 2009. And do you know what happened next? The S&P 500 index surged by 69.5% over the next 12 months. That’s a spectacular return! One moment, the market was reeling. The next moment, we began one of the greatest bull markets in history! As I write this in late 2016, the S&P 500 has risen by an astonishing 266% since its low point in March 2009.
You might think this was a freak occurrence. But as you can see on the chart above, the pattern of bear markets suddenly giving way to bull markets has repeated itself again and again in America over the last 75 years.
Now can you see why Warren Buffett says he likes to be greedy when others are fearful? He knows how quickly the mood can switch from fear and despondency to exuberant optimism. In fact, when the mood in the market is overwhelmingly bleak, superinvestors such as Buffett tend to view it as a positive sign that better times lie ahead.
You see a similar pattern when it comes to consumer confidence, which is a measure of how optimistic or pessimistic consumers feel about the future. During a bear market, commentators often remark that consumer spending has fallen because people are so nervous about the future. It’s a vicious cycle: consumers spend less money, so companies make less money. And if companies make less, doesn’t that mean the stock market won’t be able to recover? You might think so. But these periods of consumer pessimism are often the ideal time to invest. Look at the table on the next page and you’ll see that an array of bull markets began when consumer confidence was at a low point.
Why? Because the stock market isn’t looking at today. The market always looks to tomorrow. What matters most isn’t where the economy is right now but where it’s headed. And when everything seems terrible, the pendulum eventually swings in the other direction. In fact, every single bear market in US history has been followed by a bull market, without exception.
This record of incredible resilience has made life relatively easy for long-term investors in the US market. Again and again, bad times have eventually been followed by good times. But what about other countries? Have they seen a similar pattern of bear markets being followed by bull markets?
Broadly speaking, yes. But Japan has had a much tougher experience. Remember the 1980s when Japanese companies seemed poised to rule the world? Japan’s stock index, the Nikkei 225, rose sixfold during those years of giddy optimism, hitting a high of 38,957 in 1989. Then the market got blown to bits. By March 2009, the Nikkei had sunk to a low of 7,055. That’s an 82% loss over 20 years! In recent years, though, it has staged a strong comeback, recovering to a high of 17,079. Even so, the Japanese market is still way below its peak after nearly three decades.
As we’ll discuss later, you can protect yourself against this sort of disaster by building a portfolio that’s broadly diversified globally and also among different types of assets.
The stock market is a device for transferring money from the impatient to the patient.
Did you ever listen to the news and hear the announcer mention that the stock market just hit an all-time high? Maybe you got that queasy feeling that we were flying too close to the sun, that gravity was about to do its thing, that the market would inevitably fall back to earth.
As I’m writing these words, the S&P 500 stands just a few points below its all-time high. In recent weeks, it hit new highs on multiple occasions. And, as you know, this bull market is more than seven years old. So, the possibility that we may be due for a fall has probably been on your mind as well as mine. It certainly makes sense not to take carefree risks when stocks have soared for years. If there’s one lesson from Japan’s experience, it’s that we humans have a natural tendency to get carried away and lose sight of danger when stock prices have been surging.
But the fact that a market is close to its all-time high doesn’t necessarily mean that there’s trouble ahead. As we discussed earlier, the US market has a general upward bias. It rises over the long term because the economy continues to grow. In fact, the US market hits an all-time high on approximately 5% of all trading days. On average, that’s once a month.II Thanks to inflation, the price of almost everything is at an all-time high almost all the time. If you don’t believe me, check the price of your Big Mac, your café latte, your candy bar, your Thanksgiving turkey, or your new car. Chances are, they’re all priced at an all-time high, too.
Freedom Fact 7: The Greatest Danger Is Being out of the Market
I hope you agree with me by now that it’s not possible to jump in and out of the market successfully. It’s just too difficult for regular mortals like you and me to predict the market’s movements. As Jack Bogle once said, “The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible.” Even so, the fact that the market is hovering close to an all-time high might tempt you to play it safe by waiting on the sidelines in cash until stock prices have fallen.
The trouble is, sitting on the sidelines even for short periods of time may be the costliest mistake of all. I know this sounds counter-intuitive, but as you can see in the chart below, it has a devastating impact on your returns when you miss even a few of the market’s best trading days.
You miss one hundred percent of the shots you don’t take.
—HOCKEY HALL OF FAMER WAYNE GRETZKY
From 1996 through 2015, the S&P 500 returned an average of 8.2% a year. But if you missed out on the top 10 trading days during those 20 years, your returns dwindled to just 4.5% a year. Can you believe it? Your returns would have been cut almost in half just by missing the 10 best trading days in 20 years!
It gets worse! If you missed out on the top 20 trading days, your returns dropped from 8.2% a year to a paltry 2.1%. And if you missed out on the top 30 trading days? Your returns vanished into thin air, falling all the way to zero!
Meanwhile, a study by JPMorgan found that 6 of the 10 best days in the market over the last 20 years occurred within two weeks of the 10 worst days. The moral: if you got spooked and sold at the wrong time, you missed out on the fabulous days that followed, which is when patient investors made almost all of their profits. In other words, market turmoil isn’t something to fear. It’s the greatest opportunity for you to leapfrog to financial freedom. You can’t win by sitting on the bench. You have to be in the game. To put it another way, fear isn’t rewarded. Courage is.
The message is clear: the greatest danger to your financial health isn’t a market crash; it’s being out of the market. In fact, one of the most fundamental rules for achieving long-term financial success is that you need to get in the market and stay in it, so you can capture all of its gains. Jack Bogle puts it perfectly: “Don’t do something—just stand there!” Hell is truth seen too late.
—THOMAS HOBBES, seventeenth-century British philosopher
But what if you get into the market at exactly the wrong time? What if you get unlucky, and you’re hit immediately by a correction or a crash? As you can see in the chart below, the Schwab Center for Financial Research studied the impact of timing on the returns of five hypothetical investors who had $2,000 in cash to invest once a year for 20 years, starting in 1993.
The most successful of these five investors—let’s call her Ms. Perfect—invested her money on the best possible day each year: the day when the market hit its exact low point for that year. This mythical investor, who perfectly timed the market for 20 years running, ended up with $87,004. The investor with the worst timing—let’s call him Mr. Hapless—invested all of his money on the worst possible day each year: the day when the market hit its exact high point for that year. The result? He ended up with $72,487.
What’s striking is that, even after this 20-year run of spectacularly bad luck, Mr. Hapless still made a substantial profit. The lesson? If you stay in the market long enough, compounding works its magic, and you end up with a healthy return—even if your timing was hopelessly unlucky. And you know what? The worst-performing investor wasn’t the unlucky one, but the one who stayed on the bench, the one in cash: he ended up with only $51,291.
FREE AT LAST!
In this chapter, you’ve learned seven facts that show you how the market works. Based on more than a century of financial history, you now understand that corrections, bear markets, and recoveries follow similar patterns again and again. Now that you have the power to recognize these long-term patterns, you will also have the power to utilize them.
Later in this book, we’ll explain in depth the specific strategies you can use to take advantage of these seasonal patterns. For example, we’ll show you what to look for when creating your ideal asset allocation strategy, so you can minimize your losses in a bear market and maximize your gains when the market rebounds. But for now, you should have a big smile on your face! You know the facts. You know the rules of the game. You know that corrections and bears are to be expected, and you’ll soon learn how to take advantage of them. You’re one step closer to being truly unshakeable.
Best of all, you’re taking control of your financial life. You’re taking responsibility. Because you know what? Most people never take responsibility. They prefer to blame the market for whatever happens to them. But the market never took a dime from anyone! If you lose money in the market, it’s because of a decision you made—and if you make money in the market, it’s because of a decision you made. The market is going to do whatever it’s going to do. But you determine whether you’ll win or lose. You’re in charge.
This chapter has taught you that financial winter is always followed by spring—a lesson that will allow you to proceed without fear. Or, at the very least, a lot less of it. Knowledge brings understanding, and understanding brings resolve. You won’t be the person who pulls your money out of stocks when the market is getting slammed! You’ll be the one who stays in the game for the long haul—planting the right seeds, nurturing them patiently, and then reaping the harvest!
But in the next chapter, you’ll discover that there’s one thing that it’s actually healthy to fear: financial firms that charge clients like you and me outrageous fees for lousy performance. As you’ll see, there’s no more powerful way to take control of your finances than to cut out these excessive—and often hidden—fees. How will you benefit? You’ll save at least 10 years of income! How’s that for taking charge?
So turn the page, and let’s expose those hidden fees and half-truths . . .
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