Stocks will eventually crash. The key is to be financially and psychologically prepared to stay invested even when your 401(k) gets chopped in half, your job disappears, and your mortgage goes underwater.
Investing in the whole stock market is a great way to build wealth over the long run. But, just how long is “the long run”? As I am writing this on September 3, 2018, the U.S. stock market hit new all-time highs last week, after a bull market that has lasted, by some accounts, nearly 10 years. Today’s young investors may have no memory of the 2008 financial crisis, where the market declined by about 55%, from its peak on October 9, 2007 to the lowest point on March 9, 2009. For the unlucky who invested at the peak, it took about five years just to get back to even.
Although in the Great Depression, stocks declined by 90% and took 25 years to get back to even, it does not seem a depression of this magnitude will be repeated. However, something less severe than the Great Depression but as bad or worse as the 2008 financial crisis could occur. There is no way to time the market or figure out when it will occur, which is why sound financial advice looks at when you will need to spend your assets and decides the proportion of your assets that should be in stocks—diversified across the whole U.S. or global market.
I am a firm believer in the hypothesis that the duration of your time in the stock market is most important. When comparing investment gains over many years to those over shorter periods, the longer periods show greater gains. However, I have often wrote here that “the long run” is about 15 years or more. In fact, there is a recent example when stocks produced no real returns in a period longer than this: 1966 to 1982. Of course, if you stayed invested since 1966 you have seen tremendous real gains, but for investors then, the pain was profound because interest rates were high; you could earn 7% or even higher per year with 10-year Treasury bonds. As of this writing, the rate is only about 2.9%, which merely keeps pace with inflation.
If you believe the duration of investment is key, then if you receive a windfall, this means you should invest a lump sum proportionate to your asset allocation percentage into the whole stock market, despite the fact that we are historic market highs. At the same time, it is essential to be emotionally, financially, and logistically prepared for a 55% drop in stock valuations.
It is easy to look back on the 2008 financial crisis and ask why people sold their stocks rather than buying more and more. However, many Americans faced a triple whammy of losing their high-paying careers, having their mortgage payment go up and home value plummet, and taking a 40% or larger haircut on their 401(k)s and other investments (if any). Then, many cashed out their investments at fire-sale prices, just to delay foreclosure on their homes. Additionally, no one knew then that the recovery would happen so quickly and powerfully.
Being prepared for a 55% drop means having low overhead, such as a smaller home and older car. It means having a six- or even 12-month emergency fund to cover your living expenses, and enough money in low-risk accounts or investments. At all times, what you want to avoid is being emotionally swayed or financially compelled to liquidate your stocks during a temporary market crash.