Chapter 14. Stocks Will Go Down

OVER THE LONG term, the stock market is a good place to be. Between 1900 and 2020, the annualised real return on US equities was 6.6%; the global figure, excluding the US, was 4.5%. The annualised real return on UK equities was 5.4%.

That’s not bad, especially when you consider all the challenges the global economy faced in that time – two world wars, Communist revolutions in Russia and China, the threat of nuclear holocaust and the rise of global terrorism among them. Whatever else you might think about capitalism, it has proved remarkably resilient.

There is, however, a but, and it’s this: although the long-term trajectory of markets was upwards, there were frequent occasions when the patience of equity investors was sorely tested. Along with death and taxes, stock market declines are an unavoidable part of life.

Market downturns, when they happen, can be stomach-churning. Take the crash of March 2020, for example. Markets began falling in the last week of February on fears about the spread of coronavirus. There was another steep decline on 9th March. Two days later, President Trump announced a travel ban from Europe and, on 12th March, the Dow Jones Industrial Average fell 9.99%. It soon became clear that a recession was inevitable and, on 16th March, the DJIA dropped another 12.93%, or 2,997 points – the largest point drop since Black Monday in 1987.

We now know, with the benefit of hindsight, that the panic would be short-lived. The Nasdaq surpassed its pre-crash high in June 2020, followed by the S&P 500 in August and the Dow in November. But for anyone with significant exposure to the stock market these were scary times.

Since 1950, the US stock market has been the world’s top performer. Yet, in that time, even US equities have experienced double-digit losses in more than half of all years. Nine out of every ten years has seen losses of at least 5% at some point during the year. So it’s perfectly normal for markets to freak out on a periodic basis, because humans freak out from time to time as reality does not always line up with expectations.

As an investor in the stock market, you have to get used to existing in a state of loss because the market is below all-time highs the majority of the time. Since 1928, the S&P 500 has hit new all-time highs in roughly 5% of all trading sessions. If we invert this number, that means 95% of the time investors are in a state of drawdown and stocks are down from a previous high watermark.

In the short term, the reasons for market sell-offs feel like they matter a lot and downturns feel like they’ll never end. In the long term, investors tend to forget the specific reasons stocks fell in the past and all corrections look like buying opportunities.

Another benefit of making periodic contributions to your investment account is the psychological boost this can provide in the midst of a downturn. This is especially true for those just starting out on their retirement savings journey without a sizeable portfolio just yet. An investor who doesn’t have a lot of money set aside should be able to withstand larger percentage losses because the actual decline in pounds will be relatively small. On the other hand, an investor with a lot of money in their portfolio can see a relatively small percentage loss lead to a much bigger loss in terms of pounds. For example, these are the losses in pounds based on different portfolio sizes and percentage losses.

Losses in pounds at different percentage losses, portfolios of size £10,000–£100,000

Losses in pounds at different percentage losses, portfolios of size £250,000–£1m

As Captain Obvious likes to say, “The bigger your portfolio the more money you lose for a given percentage decline.” This works in both directions, as the inverse of these losses would show greater gains with larger portfolio balances as well.

When you have a small portfolio that you’re looking to make into a big portfolio, you have the ability to make up for short-term losses by increasing your savings rate. We can call this your savings replacement rate. Let’s assume you invest £500 a month, or £6,000 per year. These are the savings replacement rates for various loss levels based on these same portfolio sizes.

Losses covered if contributing £6,000 per year, portfolios of size £10,000–£100,000

Losses covered if contributing £6,000 per year, portfolios of size £250,000–£1m

A 20% downturn on a £25,000 portfolio would lead to losses of £5,000. It’s never fun to see that money temporarily disappear, but investing £6,000 in that year would more than make up for the market value loss and leave you with an ending balance of £26,000.

Captain Obvious here again – making regular contributions and sticking with it doesn’t improve your performance, but it could help you stay the course during a market downturn if you’re still able to see some progress. Here are those same results if you maxed out your Stocks and Shares ISA, which has a max contribution limit of £20,000 in the 2021–2022 tax year.

Losses covered if contributing £20,000 per year, portfolios of size £10,000–£100,000

Losses covered if contributing £20,000 per year, portfolios of size £250,000–£1m

If you have £250,000 saved in your ISA, a 20% loss would mean £50,000 has evaporated for the time being. That stings, but maxing out your ISA would cover 40% of those losses.

It’s also worth pointing out losses in the overall stock market aren’t permanent. The only permanent losses during a panic come when you sell.

This line of thinking is more about optics than anything, but psychological tricks can come in handy during down markets because behaviour is the first thing to go during stressful market situations. Sometimes you have to fool yourself into staying the course because the temptation to sell is so great when prices are all over the map.

Tricking yourself into saving more can be more useful than most people imagine because knowledge alone is never enough to change your behaviour.