Transforming personal finance since 2011

#15 — Why crashes don't matter

October 21st, 2016

By Andrew Craig

Reading time: ~ 9 minutes

Over my last two articles I have looked at whether or not I think a massive correction is coming in stock markets (and, by extension, other financial and property markets more generally).

I signed off the most recent one by saying that I basically don’t care what happens to stock markets.

To repeat:

I believe that I can arrange my financial affairs such that I am comfortable that whether there is a massive crash or whether stock markets power ahead, my ability to meet my longer-run financial goals will be largely unaffected. You should feel the same way too.

How is this possible? The answer comes in three parts:

1. Own the world

First, you need to ensure you own all or, at the very least, most major assets in most major regions of the world. This should include cash, bonds, property, stocks (shares), commodities (including precious metals) and a good split between the US, Asia and Europe (including Switzerland and the UK). As you should hopefully know by now, we call this 'owning the world'. (For those that haven't yet read my book on this, it is a great starting point).

Those of you who have followed us for any length of time should be familiar with this idea already. The wealthiest and most financially literate people in the world have invested like this for centuries. In fact, I would go as far as to argue that investing this way is one of the reasons such people became disproportionately wealthy in the first place, especially when they did this over time.

It should intuitively make sense to you why this works. In 2007-2009, the stock market more than halved but oil hit an all-time high and gold went up nearly 20% in 2009. Sometimes Asia is on fire and Europe stagnates and sometimes America is the place to be. The easiest thing to do is just do your best to own all asset classes in all areas of the world. You will never work out where the next ‘hot’ area or asset is going to be. More often than not, not even the experts get this right.

European aristocrats, Victorian industrialists or American ‘robber barons’ needed an army of bankers and lawyers to invest like this. The great news for you in 2016 is that it is far easier for you to invest like this today than it was for them. You can get started with very little money and it can all be done from the comfort of your own home using your computer or even your smart phone…

2. Automate

Secondly, you should look to automate your investments by direct debit each month if at all possible. This achieves something that will be very good for your peace of mind over time:

That something is called ‘smoothing’ or ‘averaging in’. It also removes you from the equation – which, with very few exceptions, is also a very good idea as we shall see.

To explain:

The S&P 500 index in the US (a good proxy for ‘the stock market’) fell from 1,500 in October 2007 down to the rather spooky and Biblical level of 666 in March 2009 (that is a 56% collapse. Ouch!). It then went from 666 all the way to north of 2,200 a few weeks ago and is now sitting at 2,133 as I write (that is a 220% recovery. Nice!).

The problem is - human nature is such that if you had tried to time your investments to take advantage of these moves, you would almost certainly have got it wrong. In fact, the situation is actually worse than that: There is a high probability you would have sold low and bought high and timed your investments about as badly as it is possible to.

Why is this? Because we are hard-wired psychologically to get this wrong.

We humans are pack beasts. We pay a disproportionate amount of attention to what everyone else around us is doing. Much as we fight it, very few of us have the knowledge or self-confidence to be truly contrarian. When the market bottomed at 666 in March 2009, nearly everything you would have read or seen in the news would have gone on about how risky stock market investment is and how much money everyone had just lost. Fear, woe, pessimism, anger, general wailing and gnashing of teeth. As a result, you would have been highly unlikely to have considered putting your hard earned savings into the stock market. Everyone would tell you you’d be crazy to even consider it: “Brrr. Too risky! Look what just happened!”

Even more insidious: As the market recovered from the bottom: 10% up, then 20%, 30%, 40% and all the way up to 220% (today), it will have been perfectly natural for you to say to yourself (pretty much every month): “Damn! I must have missed it now. I’m too late”. You will then not have invested.

After a year or two of this, the next thought you might have will probably be something like: “Bugger. I really must sort this investment thing out. Look! The market is up 220%. It just keeps going up. My mate has made a fortune. I’ve been avoiding it the whole time and missing out. Right. That’s it. I’m in.”

You know the rest. Just as you decide it is time to get back in, along comes the next or Lehman’s style crash and you get absolutely flattened and spend the next decade licking your wounds. The cycle repeats. This really happens. Time and time again. It is human nature. We are hard-wired to do this.

The solution is to take yourself out of the equation. You really should ignore the news completely and automate your investments. Do not try to second guess what is going to happen. Do not try to time the market and start thinking “I should buy this now or sell that now”. Do not ask supposed ‘experts’ what they think either. Just invest what you can afford, every month, without fail, into something sensible (more on this shortly) until such time as you want to live on the proceeds (a time that will arrive sooner than most people dream is possible if you do this).

In our example of the S&P 500 above – had you been automating your payments monthly, you would have bought in at 1,500 just before the crash (ouch) but then every month after the crash too (at levels along the lines of 680, 750, 850, 930, 1,000 and so on – all the way up to 2,200! Lovely!).

The net result of this approach is that you grind out consistent and meaningful returns (far higher that interest rates) through the economic cycle, no matter what is happening. Thanks to Einstein’s eighth wonder of the world - compound interest - the tortoise then thrashes the hare and you will end up with more money than you thought possible.

3. Stick to your guns

Finally, you must have confidence in your game plan and stick to your guns (doing this is far easier once you understand a bit about finance!).

Professors Elroy Dimson and Paul Marsh of the London Business school have shown that investing in UK smaller companies has achieved an annual return of no less than 15.4% going back as far as 1955!. You read that right. 15.4% a year for sixty years!

Making that sort of return on the money you save and invest will make you wealthy really rather quickly – particularly if you’re using an ISA account so you don’t even incur any tax liability. You can literally become an ISA millionaire over the course of a few years.

There is a problem, however (although it is a problem with a solution as we shall see): Although this performance track record over no less than sixty years is amazing (and almost entirely unknown by the vast majority of people other than a small minority of folks in the City), the 15.4% returns didn’t come smoothly every year. Some years smaller companies powered ahead by 30% or even 40% or more. On several occasions between 1955 and the present day, however, they fell by more than 50%.

If you refer back to section 2, above, you will understand how these falls will so often cause people holding UK small caps to give up in fear, crystallise their 50% loss and then never invest in the space again – a terrible result all round and nowhere near the 15.4% annual return they could be making. This is why having confidence in what you are doing and sticking to your game plan is so important.

When doing speaking events, I quite often say that investment success is truly 90% about admin’ and only 10% about what you invest in (within reason). If you have actually made the effort to set up an investment account with a good quality company, optimise your ISA and pension arrangements and set up the necessary regular direct debits, you will be 90% of the way to investment success. The final 10% is about choosing something sensible to make those payments into and sticking to your guns.

UK smaller companies have produced more than 15% p. annum for sixty years as we have just seen. Terry Smith’s Fundsmith Fund has produced 19.8% annualised returns for the last six years. Baillie Gifford’s Scottish Mortgage Investment Trust has returned 300% over the last ten years.

The list of these sorts of things is longer than you think, just very little known because so few people ever spend any time learning about finance.

By investing monthly in these sorts of assets and sticking to your guns, you can achieve consistent returns that are well above interest rates. Most people have no idea about any of this – which is a fundamental failure of our education system.

That said, all of the above ways of making these returns carry with them a good deal of volatility. I am delighted that one of my friends has made more than 50% in his pension fund from his holding in Fundsmith over the last two years, but I warn him every week that it will almost certainly fall a long way in the next crash. As long as he has the confidence to average down when this happens and continue to invest, he will be fine in the long run.

The problem is, that it takes a great deal of mental fortitude to do this, even if you have prepared for it. This is why owning the world is such a great strategy – because it grinds out the returns without those 50% down years which risk scaring you out of your position and making you give up on investment.

It is also crucial as you get closer to retirement.

Losing £5,000 from your £10,000 pot in your twenties is an entirely different problem to that of losing £500,000 from your £1,000,000 pot at sixty. If you own the world, you won’t have to worry about this when the time comes.

In summary

If you own the world, automate your investments and stick to your guns, you should make high single digit to low double digit returns through the economic cycle no matter what the latest headlines are.

Even better, doing this removes a great deal of worry.

Once you have done the admin' needed to put this in place, you can sleep well at night and spend your precious time doing whatever it is that you love to do, rather than waste it on following financial markets and worrying about Trump, Clinton, Syria, Brexit, killer bees, immigrants, earthquakes, aliens or whatever else the papers are trilling about this week.