Sticking With Stocks
AT A FAMILY DINNER in the early 1980s, I remember one of my brothers—probably then age 20 or so—saying, “But isn’t the economy built on sand?”
My economist stepfather offered one of his trademark droll responses: “The economy’s always built on sand.”
The same could be said for the stock market. In the minds of many investors, it’s always teetering on the verge of collapse. After two years of rising share prices, and amid concerns about high stock valuations, the election, a possible recession and the Federal Reserve’s next move, that sense of unease seems especially acute right now.
Worried about a possible stock market decline? Here are five questions to ask yourself.
1. How much money will you need from your portfolio over the next five years? Historically, over most five-year periods, stocks have notched gains, even if they posted sharp losses at some point during that stretch. That’s why I typically suggest that folks get money they’ll need to withdraw from their portfolio over the next five years out of stocks and into nothing more adventurous than high-quality short-term bonds. That way, even if share prices plunge, investors should be able to sit tight and postpone any selling until share prices recover.
Indeed, when I talk to investors, I typically find they’d have no financial need to sell stocks over the next five years. Between their regular income—whether it’s from a paycheck, Social Security or a pension—and the money they have stashed in bonds and cash investments, they could easily wait out a big stock market decline. Still, there is risk—the risk these folks will make a panicky decision and dump stocks at depressed prices.
2. How much in new savings will you add to your portfolio in the years ahead? If you’re 30- or 40-years old, the biggest part of your future retirement portfolio is likely the cash you’ll invest between now and when you quit the workforce.
Let’s say you’re age 40, you have a $200,000 portfolio that’s entirely in stocks, and you’ll save $10,000 a year—or $250,000 total—between now and age 65. Arguably, your retirement nest egg is just 44% in stocks. Moreover, at least some of the money you’ll sock away over the next 25 years could be used to take advantage of stock market declines.
A key reason we’re free to invest heavily in stocks early in our adult life is our human capital—the fact that we don’t need regular income from our portfolio because we’re collecting a paycheck. As I see it, counting future savings as part of our cash holdings is one way to factor our human capital into our portfolio’s design.
3. How much of your wealth is invested in stocks? The market is a whiny child that’s forever throwing tantrums and demanding our attention. Yet, despite all the focus on the stock market’s ups and downs, it’s often a relatively small portion of many folks’ wealth.
Think of everything you own: stocks, bonds, cash investments and real estate. If you’re taking a broad view of your wealth, you might also include the value of your human capital, any business you own, Social Security, and any pension or income annuity you're entitled to. For those who aren’t retired or close to it, their ability to earn an income is likely their most valuable asset. You might even put a value on your household possessions and the cars that you own, though I’d discourage this. These probably aren’t things you can readily sell—because you can’t reasonably live without them.
Result? Do the math, and you’ll likely find stocks are a small part of your overall wealth, and hence any market slump would put only a modest dent in how much you’re worth.
4. How much could you potentially lose in a market crash? In a bear market decline, stocks lose some 35% on average. To think about what that loss might mean in dollar terms, take the total value of your stock portfolio and multiply it by 0.35.
Would that sort of short-term loss freak you out—or would you take it in stride? I suspect most folks will find the potential dollar loss is modest relative to their total wealth. But if the possible short-term hit seems unbearably large, this is probably a good moment to dial down your stock exposure, while share prices are near their all-time high.
5. How bad is the economy? The stock market’s long-run return is driven by growth in corporate earnings, and that hinges on the economy.
If the economy contracts, and you assume it keeps shrinking for many years, it’s easy to justify a huge drop in the stock market because of the massive hit to corporations' intrinsic value. That’s the sort of scenario that many investors—both professionals and amateurs—are apparently assuming whenever a recession looms and they think it makes sense to unload shares at 20% or 30% off. And yet, to find a stretch where we had negative economic growth for more than two calendar years in a row, you’d have to go back to the 1930s and 1940s.
What about recent decades, during which the government has been quicker to step in and help revive economic growth? The U.S. economy has been far less rocky. For instance, inflation-adjusted gross domestic product contracted 2.6% in 2009’s Great Recession and 2.2% during 2020’s pandemic. In both cases, the economy made up that lost ground the following year.
In other words, while a huge stock market decline might make sense if the economy shrank for multiple years in a row, that simply hasn’t happened in recent decades. Feeling nervous? Ignore your fellow investors—and instead pay attention to the U.S. economy's remarkable resilience.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier articles.The post Sticking With Stocks appeared first on HumbleDollar.
