Downturns this deep can take a long time to recover from, financially and mentally

We always say that investing in the stock market is for the long term, with volatility and the risk of loss as part of the “price of the entry ticket”. How we respond to these downturns can have a big impact on our future wealth.

Dash for cash, stick with stocks, or double-down?

There are three common investor responses to a market crash:

• Dash-for-cash: abandon the stock market in favour of the perceived safety of cash
• Stick-with-stocks: the “do nothing” approach
• Double-down: invest additional money in the stock market, either as a lump-sum or by drip-feeding money in

Lump-sum investing exposes investors to the risk that they make that investment at a bad time, adding the challenge of trying to pick exactly the right time, when the market is about to start recovering. It also assumes that investors can access a large cash pile to finance that investment.

In contrast, the drip-feeding approach is a bit like “buying low” but with the humility to accept that we have no idea when the lows will occur. “Buying lower” (than before) might be a better description. In the remainder of this article, we assume that this is the approach taken in the double-down response.

The response matters

There have been 11 occasions in the 148 years between 1871 and 2019 when stocks (as measured by the S&P 500 Index) have destroyed at least 25% of value for investors. We analysed how long it would have taken for an investor’s portfolio to get back to its pre-crash value under each response. We assume that an investor is choosing between these responses when the market has already fallen by 25%. This is the position that many investors find themselves in today.

In the double-down response, we have assumed that an individual invests an annual amount equivalent to 5% of what the portfolio is worth in the month when it first declines by at least 25%. It follows that investing new money will increase a portfolio’s value faster than doing nothing. As a result, we have also calculated the length of time to get back to the pre-crash level plus the value of additional investments. This final figure is fairer for comparison purposes and all comments which follow relate to it.

There is a real risk that individuals are so scarred by recent experience that they are put off from investing in the stock market for a long period of time – and dash for cash. However, historically, that would have been the worst financial decision an investor could have made. It pretty much guarantees that it would take a very long time to recoup losses.

For example, an investor who shifted to cash in 2001, after the first 25% of losses in the dotcom crash, would find their portfolio today still worth only around 90% of its year-2000 value.

The message is clear: a rejection of the stock market in favour of cash would have been very bad for wealth over the long run.

Actions have consequences

Everyone’s circumstances are different and this is in no way intended as financial advice. Nonetheless, for those who are already invested in the stock market, the steps you take now will have an impact on how your portfolio recovers from the current downturn. Anyone thinking of moving to cash should consider the consequences, with savings rates at close to zero. 

No one has a crystal ball to be able to predict how and when the current downturn will end. Risk of loss is the price of the entry ticket for the stock market. Higher long-term returns are the potential payoff. The mental scars of what we are living through will be with us for a generation, but the financial scars need not be.