What’s the Best Age at Which to Experience a Stock Crash?

By in Advanced Investing, Asset Allocation, Economics, Guest Post, Investing, Stocks | 17 comments

We have records of the performance of the stock market dating back to 1870. During that time we have experienced four stock crashes. The market tops came in: (1) 1900; (2) 1929; (3) 1965; and (4) 2000. Stock returns were poor for the 20 years immediately following each of the first three crashes and so far for the first 12 years immediately following the fourth crash.

Crashes obviously hurt all investors (and, indeed, even non-investors — the losses suffered in crashes cause economic crises which dramatically diminish economic growth for the entire society in which they occur). But they don’t hurt all investors to the same degree or in the same way.

This column looks at how crashes affect investors at four stages of the investing life cycle in different ways. The four stages are:

(1) Young Investors (age 25 to age 45)

(2) Investors Approaching Retirement Age (age 45 to age 65)

(3) Investors in the First Decade of Retirement (age 65 to age 75)

(4)Investors Beyond the First Decade of Retirement (age 75 forward).

 Young Investors (Age 25 to Age 45)

The dollar hit delivered to these investors is minimal. In fact, looking only at the dollar hit, it can be argued that stock crashes benefit this group.

An investor close to retirement age might have $1 million in his portfolio. A price drop of 65 percent would cost him $650,000. That’s a devastating hit. It’s far better to take the hit at a time when you only have $100,000 in your portfolio. The $65,000 loss might seem like a big deal to the person with only $100,000 of life savings. But crashes only occur once ever 35 years or so. So getting the crash out of the way when you are 35 means not needing to worry about the next one until you are 70. The investor who experiences a crash early in his investing lifetime will see huge gains uninterrupted by crashes in the years of greatest wealth accumulation (the late 40s, 50s and early 60s).

There’s another side to the story. Crashes cause economic crises. Younger workers are far more in need of job opportunities than older, better established workers. Experience a crash in your 20s or 30s and you may never see the career growth you need to see to be able to retire at a reasonable age. It’s good to experience your stock crash when you are young if you have a good job before the crash hits. If the crash hits before you are established in your career, it could be that the hit you experience from not being able to obtain a good job will be far larger than the hit you experience as a result of a drop in your portfolio value.

For young investors who have established themselves in good careers before a crash hits, the crash can actually be a big plus. Stock valuations always go to one-half of fair value before the bear market comes to an end. When stocks are priced at one-half fair value, the most likely annualized 10-year return is 15 percent real. Young investors experience small dollar losses in a crash and are then positioned to experience huge gains in the years when they are earning enough to invest heavily in the market.

Investors Approaching Retirement Age (Age 45 to 65)

Since crashes only come once ever 35 years or so, those experiencing crashes in the years leading up to retirement enjoy a good number of years of compounding returns before the crash takes place. This gives them the opportunity to accumulate large amounts of wealth.

The problem is that investors who accumulate large amounts of wealth without suffering a crash often come to believe that they are immune to the market laws that insure that we will see crashes ever 35 years or so. Investors who enjoy big gains for decades often ramp up their spending on the presumption that there will never again be a crash. This hurts them in three ways.

One, they become accustomed to a living standard far beyond what they will be able to afford after the effect of the upcoming crash is taken into consideration. Two, they lose the ability to see gains on their portfolios once the crash hits (remember, stocks provide poor returns for 20 years following a bull market top). And, three, these investors take their hit at the worst possible time for doing so, when their portfolio values are nearly large enough to finance a middle-class retirement.

Investors in the First Ten Years of Retirement (Age 65 to Age 75)

This is the worst time to experience a crash. The historical data shows that retirees that survive ten years without being wiped out in a crash almost always work until the investor’s death. But even portfolios that appeared on the day the retirement began to be plenty large enough to support a long retirement can fail if there is a big hit in the first ten years of the retirement.

The problem is the compounding returns phenomenon. Investors who count only direct dollar losses greatly underestimate the price they pay for living through a crash. Each dollar lost is a dollar that would have been generating compounding returns for many years to come had the crash not taken place.

Non-retired investors can mitigate this effect by making new contributions to their portfolios, contributions likely to earn big returns because the market always dishes out truly mouth-watering returns in the years following the end of a bear market. But retirees are not able to make new contributions. They suffer all the downside of a crash and none of the upside.

Investors Who Have Been Retired More Than Ten Years (Age 65 and Up)

These investors suffer the smallest hit. It’s scary to see a huge drop in your portfolio value at an age when you are not able to return to the workforce. But the financial reality is that, if your retirement was adequately funded at the outset and you went 10 years without seeing a major hit, you have experienced enough gains that your plan should work even if you live a long life.

The one big downside to a crash for investors who have been retired for more than ten years is that it reduces the amount that they will be able to leave to heirs and to charities.

Barb’s comments; I would be remiss without giving a remedy to the chilling impact of large scale stock market investment declines. Asset allocation, tailored to your age and risk tolerance will soften the blow of market drops. If you are in retirement, you should have a large portion of your investment dollars in cash and fixed assets, so that when the stock portion of your portfolio falls, the impact will be cushioned by the stable value of cash investments.

Rob Bennett recently posted a review of the book The Myth of the Rational Market. His bio is here.

How have the recent stock market delines impacted your investing strategies?

image credit; astrycula

    17 Comments

  1. Great analysis. I think that being young would be the best time.. but then one would have to have the foresight and the cash to buy more when its down.

    I would be very upset if I lost all my savings when I’m close to retirement, though they say you should have more fixed income investments instead of equities then.

    youngandthrifty

    January 23, 2012

  2. There have been lesser crashes that had similar impact as well. It may be lesser, but it still has impact. You are right asset allocation will help lessen the impact.

    krantcents

    January 23, 2012

  3. I do not think there is a good time to experience stock crash whether you are old or young. It still hurts the economy which in turn will hurt people from all ages.

    Cedar Creek real estate bonita springs

    January 23, 2012

  4. I also think being young is the best time. You have the time to recover and rebuild while you are still working. I would still be upset but I wouldn’t feel hopeless like I would when I was older.

  5. Thanks for all the good comments. I don’t usually get so many!

    Rob

    Rob Bennett

    January 24, 2012

  6. My take is that demographics do not favor investment for the next decade or more. The boomers have bought a lot of investments (as evidenced by record low bond yields and relatively high Shiller PE). In the process of retiring and dying, all that stuff’s going to get sold. It doesn’t make sense to go long stocks or bonds immediately in front of a giant wave of sellers. I lay out this thesis in more detail here: http://www.offroadfinance.com/2011/11/07/why-im-a-speculator-rather-than-an-investor/

    Also, any list of stock crashes probably ought to include Oct. 1987. That was the biggest post-WWII crash – over 20% of the S&P’s value in one day.

    W-at-Off-Road-Finance

    January 24, 2012

  7. Thanks much for stopping by, W-at-Off-Road.

    Rob

    Rob Bennett

    January 24, 2012

  8. Barbara,

    I agree with you that, in general, it is better to take hit hit when you are young as you don’t have a large nest egg and you have time to accumulate wealth.

    In you list of crashes, I’d like to suggest if you can add 1987. It certainly was a major crash due to S & L debacle.

    Shilpan

    Shilpan

    January 25, 2012

  9. I was 22 years old when the stock market started taking a dive. I started investing a year or so later and it has paid off for me already (now that the market is climbing again). Plus, I am now enjoying my new house at a 50% discount of it’s value only 5 years ago. Not only did the recession not hinder my life, I think it actually helped it!

    Derek@CreatingAPassiveIncome

    January 26, 2012

  10. I’d like to suggest if you can add 1987. It certainly was a major crash due to S & L debacle.

    Thanks much for your comment, Shilpan.

    When I investigated crashes for purposes of writing the article, I looked only at four: (1) the crash that took place in the early 1900s as a result of the massive overvaluation in the 1890s; (2) the crash that took place in the 1930s as a result of the massive overvaluation of the 1920s; (3) the crash that took place in the 1970s as a result of the massive overvaluation of the 1960s; and (4) the crash that took place in the early 2000s as a result of the massive overvaluation of the 1990s.

    It certainly is true that prices took a major drop in 1987. But the drop was not long-lasting (that is, prices recovered quickly). So long as you stuck to your long-term plan, that crash did not hurt you.

    All of my thinking on investing issues is informed by the research of Yale Economics Professor Robert Shiller, which showed that valuations affect long-term returns (that is, that the prices we see at one time-period influence the prices we see at other time-periods). Shiller’s research is at odds with the research of University of Chicago Economics Professor Eugene Fama, who believes that prices are set anew each day as the result of investor reactions to new economic developments. It is Fama’s thinking that informs the Buy-and-Hold strategy and indeed 90 percent of the investing advice we hear on television and the radio and the internet.

    People are of course free to consider other crashes than the four I took into consideration. I am just letting people know how I came to the conclusions I did. My view is that all investors should be invested for the long-term. If you are invested for the long-term, it is only those crashes that hurt your portfolio value for decades (those that were caused by overvaluation and not some temporary phenomenon that can be quickly resolved) that matter.

    This discussion illustrates a point that I make frequently in my writings — that following the strategy (Valuation-Informed Indexing) rooted in a belief in Shiller’s research leads to a very different place than following the strategy (Buy-and-Hold) rooted in Fama’s research. Those following the different bodies of research are basing their decisions on different fundamental premises about how stock investing works and thus are essentially speaking different languages.

    Rob

    Rob Bennett

    January 26, 2012

  11. Not only did the recession not hinder my life, I think it actually helped it!

    It is my (controversial) view that you are advancing a very important point, Derek. My guess is that I might take it to places that you are not entirely comfortable taking it yourself.

    As I mentioned above, I follow Shiller’s research, not Fama’s. If you follow Shiller’s research, you believe that the prices that apply at one time-period affect the prices that apply at following time-periods. When prices are insanely high, as they were prior to the 2008 crash, stock investors never see good long-term returns (there has never yet been a single exception in the historical record). When prices are moderate or low, stock investors always see good long-term returns (again, there has never yet been an exception).

    This means that the dramatic lowering of stock prices we saw in 2008 will be paying off for us all for many years to come. Unfortunately, prices were so high in the pre-2008 years that even after the crash they remain high today and we cannot realistically expect good returns until after we see another crash. But we are certainly in a lot better shape today than we were in the pre-2008 years. Things are very much moving in the right direction (for stock investors, not for the economy as a whole).

    The way to think about it (in my view!) is that it is bull markets that crush investors, not bear markets. Bull markets cause long-term returns to drop to very, very low levels. A regression analysis of the historical return data shows that the most likely long-term return for stocks purchased in 2000 was a negative number. Money markets offered a far better value proposition than stocks at the time! Stocks offer a somewhat better deal today and will offer a positively mouth-watering long-term value proposition after the next crash.

    This is tricky for lots of people. We have become accustomed over the Buy-and-Hold years to thinking of bull markets as a good thing. If Fama’s research were valid, bull markets really would be a good thing. But if Shiller’s research is valid, bull markets are a very, very bad thing.

    Unfortunately, we haven’t had much discussion of which model for understanding how stock investing works is the right one. Shiller’s breakthrough research was published in 1981. The biggest bull market in history followed before his findings became widely known and appreciated. During the wild bull market, everyone fell in love with Buy-and-Hold and Shiller’s findings were ignored. We are beginning to see them paid a bit more attention since the crash and the economic crisis that followed from it (runaway bull markets inevitably cause economic crises, according to Shiller’s research).

    Rob

    Rob Bennett

    January 26, 2012

    • @Rob, Thanks for you thoughtful insight into two different prominent theorist. Personally, if you have a strong stomach and conficence in the US ans world economies, the most money is made when you place your investment dollars into the market after a crash.
      @Derek, It takes confidence to dive into the market when sentiment is negative and fear abounds.
      @Off the road-Predicting the future is a difficult business. I wouldn’t ever be 100% out of the market because the greatest gains are made in a few large upward days. If you miss those days, you are out of luck.

      Barb

      January 26, 2012

  12. I think another negative for the young investor (at least for this guy) is that the crash can limit the risk you are willing to take throughout the rest of your time. This will hinder long term results forever!

    Evan

    January 30, 2012

  13. That’s an outstanding point, Evan.

    It’s the kind of point that people rarely mention because we usually think of investing as being a numbers-oriented discipline and it is hard to illustrate the point you are making with numbers. The reality (in my view!) is that the numbers part of the investing project is the easy part. It is the emotions part that is the hard part of the project.

    You are 100 percent right that those who experience a crash early in their investing lifetimes are likely to shy away from stocks for many years to come and that this is likely going to delay their retirements by many years. I wish that we saw a lot more discussion of this sort of point in lots of different places.

    Rob

    Rob Bennett

    February 3, 2012

  14. I didn’t worry too much about the 2008 crash. I was young, just started working, and just started saving. It was a help for me. 😉

    Invest It Wisely

    February 4, 2012

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