The Seas Of Change

Quick question:  How much of what you do as an investor is done on faith?  The belief that you’ll continue to earn good returns from your favorite asset class.  I ask, because even though we happen to be living in an Age of Prosperity, many investors are largely relying on blind faith when investing in the stock market.

“I put money in my 401k every month, and I have faith that over time the value will continue to go up.”

Sound familiar?  It’s a common sentiment if you talk to your friends and neighbors about stocks.  The average Joe doesn’t even bother to look at the hard business numbers, he simply plows his money into the stock market every month on faith.  Without even thinking twice about it.

So I wonder — Where does all this faith in the stock market come from?  Probably historical returns and ‘social proof’.

For over a decade now stocks have consistently gone up, and over the last 70 years the U.S. stock market has seen a dramatic rise:

The last 70 years (after WWII) have been *really* good to investors.

This historic long-term consistency of returns has created a lot of public faith in the power of stock investing.  So much so, that the average investor now believes (rather arrogantly) that “the stock market will always go up”.  Year after year, investors expect to see gains in their brokerage account.

What investors forget, is that along the way there have been some serious speed-bumps on the investing road — periods in history where the average investor actually lost faith in stocks…


A Lost Decade (Or Two)

As a perpetual student of investing, I always like to study the periods in stock market history when stocks didn’t get the same amount of love they do today.  They’re often called “Lost Decades” and they’re super interesting from the standpoint of seeing how positive investor sentiment first fuels stock market returns … and then quickly reverses direction when investors lose faith in the asset class.

The first really well-recorded periods in history when stocks went from a “well-loved investment vehicle” to a hated asset class, was during the Great Depression.  Starting with Black Tuesday on October 29th 1929, stock prices were absolutely crushed.   The Dow Jones Industrial Average would lose 89% of its value before reaching bottom in 1932.

The seriousness of the market decline turned-off many investors to stocks.  It would take 27 years from start-to-finish before stocks finally recovered again to pre-Great Depression levels. (Even though it only took a decade for employment levels to recover and GDP to start rising again.)

great depression employment
Unemployment levels were high for about a decade following the Great Depression. Faith in stocks took far longer to return to previous levels.

You could say investors learned a valuable lesson during the Great Depression, about investing on faith.  Has the current generation forgotten those hard-earned lessons?


The 1970’s And Stagflation

The second historical period that stands-out was the era of Stagflation and the Oil Embargo crisis.  From 1969 to the middle of 1982, stock prices were essentially flat.  Real returns were actually negative when you take into account inflation.

During this time period the 10 year yield on U.S. Treasuries peaked at 15.3%.  Meanwhile, inflation reached an annual average of 12.4%.  This 13 year period would finally end with a recession (from 1981 to 1982).

1970s stock prices
The stock market of the 1970’s provided over a decade of flat returns — actually negative returns if you take into account inflation.

Think about that for a second — A 13 year period of negative stock returns after inflation.  Would you keep plowing your hard-earned dollars into the stock market with returns like that?

When I talk to investors that were alive during this era (I know a few), they almost universally put money into bonds during this time.  Stocks were seen as too-risky.  Stocks were (mostly) money losing investments when considering inflation rates.  Even though businesses historically earned 10-12% on capital, that 12.4% inflation would essentially “eat” every bit of earnings due to the rising replacement cost of business assets.

Growth was a non-existent dream and the average business was simply treading water.  Bonds were the way to go for any sensible investor.  I’ve been told in the 1970’s you could purchase a municipal bond earning around 15% for 30 years.  That’s a pretty incredible investment when you consider inflation would eventually settle down to 3% before those 30 years were up.

During the 1970’s even Warren Buffett was only averaging around 20%.  He moved almost his entire portfolio to asset-light investments like newspapers, television broadcasting, and insurance.

It truly was an era where investor sentiment around stocks was 180 degrees different than today.


The DotCom Era And The Great Recession

From 2000 to 2009 there was another one of these lost decades — bookmarked by the Dotcom bubble and the Great Recession.  During this time period the S&P 500 returned around -0.9%.  You’d have been safer investing in bonds.

During the Dotcom bubble, it was internet stocks that fueled the stock market euphoria.  Annual returns of 100% were not uncommon if you invested in internet stocks during the Dotcom era.  I saw some of these wild returns myself.  Valuations didn’t matter, it was growth and “eyeballs” that mattered.

netscape navigator box
Anyone remember Netscape? During the Dotcom bubble, wildly unprofitable businesses were the darlings of the stock market!

Then, it all came crashing down.  Investors eventually turned sour on stocks.  Real estate then became the new “hot” asset class.  Grandmothers and bus drivers started flipping houses for profit.  We all know how that one ended!

This modern ‘lost decade’ is generally considered to have lasted from 2001 until 2009.

Of course we only see these investing problems in hindsight, when we look backwards.  Hindsight is always 20-20.  When we’re in the thick of it (before the Dotcom bubble or the Great Recession) those investments always seem like the right way to go.

Either faith is blinding or blind faith is a mistake.


The Future Will Be Different

History provides us with these wonderful examples of how sentiment can rapidly change, but investors frequently scoff at the idea they’d lose their investing faith.

“It doesn’t matter what price I invest at.  If markets go down, I’ll just keep investing and average-down.  Over the long-term I’ll do OK”.

Theoretically, yes that’s true.  But can you really keep the faith for a decade without returns? — When everyone around you has shifted to different asset classes?  Social proof is a really powerful thing.  Can you swim against the crowd for a decade or more?

If history has shown us anything it’s that faith is not a good idea.   Past returns are no guarantee of future results.  Just because stocks have historically done well, there’s nothing that proves they’ll do well in the future.  The future is likely going to be very different from the past.

Different how?  I have no absolutely no idea.  My crystal ball is permanently cloudy, and I have no ability to predict the future.

But there are a whole bunch of investors that believe we’re “long overdue” for a recession.  Maybe so!  The next investor sea-change could be right around the corner!  Will it be crowd-funded real estate that’s the next hot asset class?  Or rare-earth elements?  Who knows!

It’s impossible to tell when, where, or what will be the next big investing fad.  But I do know this — When the sea of change finally happens, the direction it goes will bring the returns with it.  Essentially this leaves other asset classes (like stocks) out to dry.


Keep The Faith… In Time Tested Principals

So after all this, you’re probably wondering — Is the average investor doomed?  Will the next lost decade crush stocks and have average investors chasing returns only to get crushed again?

It’s a very good question, and it’s one I frequently ask myself — How will I survive the next big sea change?

Thankfully history has provided a number of hints — Strategies that have worked rather well through history.

1.  Be Adaptable.  When investor sentiment shifts to different asset classes, don’t get hung up on what was historically successful.  Invest in what works in your time period.  Maybe that’s bonds.  Maybe it’s crowd-funded real estate.  Find out what works and then do it.

Don’t get hung up on the past.  Previous popular asset classes may never recover to their historical highs.  Just ask Japanese stock investors in the early 1990s, or Dutch tulip bulb investors.  They’re still waiting for a recovery.

2.  Return Of Investment, Not Return On Investment.  Investors always focus on the wrong things.  Most of the time they’re focused on how big the returns are going to be.  It’s only after a major market crash do you finally have investors wondering how the hell they’ll get their money back out.

Most investors sell at loss or hold onto the investment, hoping for better days.  This is a backwards way to invest.  It requires too much faith.

Instead, the very first question every investor should be answering is “How will I get my money back out?”  If finding a greater fool to sell to is your answer, then you might have a serious problem.

3. Don’t Over-commit To One Asset Class.  I see this mistake all the time.  Investors will commit 100% of their money to one asset class in order to “maximize” returns.  Right now I see investors going 100% into stocks in order to realize the best possible returns.  Unfortunately these same investors end-up chasing returns.  They do poorly as a result of constantly missing the boat.

My advice?  Don’t over-commit to one asset class.  History has shown us there will be eras where bonds do well and stocks do poorly.  Or real estate does well and bonds do poorly.  Or any combination of different asset classes you can dream up.

The only way to truly catch these returns is to already be invested in them when next the big wave hits.  To do that, you have to spread your money around a little.  You won’t always see the best possible returns, but you will see consistent returns.

4.  A Bird In The Hand Is Worth Two In the Bush.  I’ve said it many times before — Don’t overpay for growth.  Unfortunately this kind of speculative behavior is all too common.  Investors are frequently willing to vastly overpay for growth that might happen instead of focusing on value that can be purchased today.

History’s biggest market sea-changes have shown us that speculative growth might never actually happen, yet investors frequently overpay for growth stocks.

My advice?  Focus on investments that are “a bird in the hand” AND might have a hidden “bird in the bush”.  In other words:  Find good current value and then don’t overpay for potential growth.  Growth is good, but don’t pay too much.


Final Thoughts

Personally, I don’t have enough faith to keep putting money into the stock market with 0% or negative return for a decade.  After 20 years of investing and 2 recessions, I’ve learned not to trust the stock market too far.  It won’t do what I want it to, and my predictions of the future usually don’t come true.

In some ways, I’m incredibly lucky — I’ve been alive during an incredible bull market and seen some great returns.  But I’m also experience enough to know that this bull market won’t last forever.  The tide will turn again some day, and I don’t want to drown in the waves.

Will I be ready if the markets crash like they did at the start of the Great Depression?  Could I still maintain my financial independence if the markets return nothing for an entire decade?  Having a lot of cash helps, but will it be enough?

These are difficult questions for the average investors to answer, and sometimes there aren’t any good answers!  But thinking will always be a preferable activity to blind faith.

So don’t let your thinking muscle get too weak in this era of easy returns!  Some day you might need it again.


[Image Credit: Flickr1, Flickr2, Wikipedia, BusinessInsider]

10 thoughts on “The Seas Of Change

  • June 12, 2019 at 6:08 AM

    So I wonder — Where does all this faith in the stock market come from?

    Ultimately the faith comes from the fact that capitalism, with all of it’s flaws and shortcomings, has proven itself to be the best system for human prosperity and wealth creation. It’s under fire in a big way in America right now and the next election will test the theory once again.

  • June 12, 2019 at 2:49 PM

    I think about this quite a bit and wonder if I can be strong for that long of a period of time. It’s easy to say, “No problem” when we’re in a bull market, but after a decade of the market in the toilet, it could easily ruin your faith in it.

    Like you, it also makes me wonder about my financial independence. If the market takes a dive for maybe 5-7 years, we should be good. But any longer and I’ll be working at Home Depot! 😉 And being a new retiree, sequence of returns risk will likely be hot on my mind for a while!

    — Jim

  • June 12, 2019 at 6:59 PM

    Excellent post Mr. Tako and you hit a sentiment I have fallen trap to, saying the stock market will always go up in the long run. But a lost decade in early retirement could be disastrous.

    Diversification is the key. Hopefully when the sea changes I won’t be carried out along with it.

  • June 13, 2019 at 6:37 AM

    Funny, 2000 to 2009 didn’t feel like a lost decade to me. I kept investing and I felt fine about it. The good thing is that our portfolio was pretty small in 2000. With dollar cost investing, it worked out well. Now that we’re older. It’s more about protecting our investment. A big crash would hurt a lot more now.
    Our asset allocation is 60/40 now, but that’s about as low as I’m willing to go.
    I still have faith in our free market system.

  • June 13, 2019 at 3:04 PM

    Stocks being horrible for a long time is terrifying for sure. I guess that’s the nice thing about the 4% rule. He factored in the worst of the worst and got to 4% (I think the worst time to retire was right before stagflation).

    Im with you on diversification though. Im all stock and bond index funds with a bunch of houses on the side (I think I can have faith they will always generally have renters in them).

    I don’t apply those rules to my funny money for stock picking which I have for fun. I put it into oil a while ago since it was so low. ‘How could it go lower’ I thought? Ack

  • June 14, 2019 at 9:43 PM

    Excellent post to get you thinking! I think you highlighted basically risk aversion or our appetite for risk. Stocks are definitely a risk asset. It makes sense that if you’re a very risky person or risk doesn’t bother you then perhaps 100% in stocks is the way to go.

    The fact is, if we try to second guess our asset allocation constantly and jump from one asset to another, then we’re just market timing and that’s a losers game.

    I think the best thing is, like you state, is assess your appetite for risk. Then stick to your asset allocation. Several years later, assess again and adjust accordingly.

  • June 25, 2019 at 11:46 AM

    This is exactly why I got into rental properties. I do have a healthy stock market portfolio, but a large percentage of my plan is in rental properties. I don’t care if the values of my rent houses go up or down as long as the rent continues to flow in. I also noticed that a lot of people rent instead of buy when the stock market really crashes (probably because of the sentiment of instability). This is why it is so important to diverse your income streams.

  • July 21, 2019 at 5:29 PM

    Like the way you think.

    This is where you are on the path to wealth comes in. If I was just starting out in the growth stage, a market correction wouldn’t bother me, I would simply keep investing. Thing is, I’m in the preservation stage and am fortunate enough to have a little left over to keep investing.

    Locked myself into a couple of horrible mortgages several years ago and they are starting to work. Have been putting my “extra” into the US markets and it has performed well for the last several years.

    Have also been thinking about this a lot lately and have come to accept, good things don’t last forever. I sense a change in the wind and today I am putting that extra into different assets. Figure I’m diversifying and that is always a good choice, over the long term.

    Like the way you broke things down. Your article, and all the comments, helped me feel better about my choices. Thank you.

    Good luck to us all.


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