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

By in Advanced Investing, Asset Allocation, Economics, Guest Post, Investing, Stocks

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