I fully anticipate a steep drop in the stock market in the near future. If I were to guess, I would say it will come in 2017, but maybe it will be next year.
So what am I doing to prepare for the upcoming dip?
Nothing at all.
Predicting the Market
The problem is that we’re all terrible at predicting what the stock market will do.
See the two articles that I linked to above when saying that we’re overdue for a recession? They both argue that we’re going to get hit with a recession in 2016. (The second one even says it will be worse than the 2008 recession!) This obviously didn’t happen.
And everyone else in the world has the same access to the knowledge of the risk of a trade war under Trump and the potential for a border adjustment tax under the Republican Congress. Those facts are already taken into consideration when people decide whether to buy or sell and how much to pay.
In fact, the Efficient Market Hypothesis suggests that it is impossible to outperform the stock market because everything that we know is already baked into the value of the stocks.
Any actions that I take to try to predict the market will probably just end up costing me. And unless you’re new around here, you know some numbers are coming up next.
Every year the Dalbar Quantitative Analysis of Investment Behavior is released. This annual report measures the effects of investor decisions on their returns by comparing the rate of returns that people actually receive with the broad market indices.
Basically: Are people beating the market?
And the answer is no. The answer is always no. And it isn’t even close. Investors are the Washington Generals and the market is the Harlem Globetrotters.
Take a look at the following chart from the report:
Over thirty years, the average equity fund (stock mutual fund) investor made 3.66% per year. The S&P 500 grew at 10.35% per year.
Investors lost out on almost 2/3 of the gains!
Plugging these numbers into a compound interest calculator makes the point even more starkly. Someone investing $100 per month for thirty years at 3.66% will end up with $65,611.39. Someone investing $100 per month for thirty years at 10.35% will end up with $248,051.10.
You almost quadruple your money by switching from average investor returns to matching the market.
So why are we so bad at keeping up with the market?
Identifying the Problem
The Dalbar report breaks down the different causes that contribute to investor underperformance. The number one cause (by a lot) is investor behavior. Number two is fees.
There are a whole slew of cognitive biases and psychological traps that get in the way of making good decisions in the stock market. We can review them each in turn in future articles if people are interested, but for now it is enough to recognize that there are a ton of things going on in your brain that are impacting your decision-making without you even realizing it.
It is also important to remember that when timing the market, you need to be right twice. It is not enough to predict when the stock market is going to drop and pull my money out. I also need to be able to predict when it will go back up and put my money in at the right time. As we’ve seen, it is hard enough to be right once when guessing what the market will do.
The second issue, fees, are a sneaky sap on our returns. One type of fee is the commission that we pay when we buy or sell stocks or mutual funds. Another is the management fee within the funds themselves.
Fees are easy to ignore because they feel very small each time they hit, but according to the report, they cause over 20% of our underperformance.
What Do We Do?
First, let’s stop trying to beat the market. The numbers show that we are likely going to fail, and fail big. Instead, let’s invest in low-fee index funds that track what the market is actually doing.
For example, VTSAX, VTIAX, and VBTLX are Vanguard funds that track the total US stock market, the total international market, and the total US bond market, respectively.
As Warren Buffett showed us, these simple index funds can outperform some of the best investors in the world. And when Warren Buffett gives investing advice, I listen.
Next, if problem number one is investor behavior, then let’s remove our behavior from the equation. Let’s automate as much as possible.
If you use a 401(k), then you have used automated investing. Every payday a portion of your check goes into your 401(k) and is automatically invested into whatever asset allocation you designate.
I have taken this logic and carried it on to my taxable investment account. The day after pay day, Vanguard automatically pulls a set amount from my bank account and invests it in my previously-selected funds. When I get a raise, I increase the dollar value of that automatic transaction, but otherwise I do not touch it.
The decisions are completely out of my control and my cognitive biases cannot cause me to make bad decisions. This change alone eliminates much of the cause of underperformance.
It is important to note here, that automating and tracking the market means that you will get the highs, but you will also get the lows. If you take this route, then you need to be sure that when the market suddenly drops, you will stick to your plan.
Would seeing half of your money disappear like it did in 2008 spook you? Are you at risk for bailing on your plan if that happens? Then it may be a good idea to put a financial advisor between you and your money. Advisors have been through the ups and downs and have carried clients through them. They can be there to talk you off the ledge if needed.
Personally, I am still a DIY investor, but you need to know yourself well enough to determine if that approach is right for you.
Finally, let’s look at fees.
We can minimize management fees by investing in low-cost index funds. Vanguard, Charles Schwab, and Fidelity all offer broad index funds with expense ratios of under 0.1%. We already know that we can’t beat the market, so why not buy cheap funds that track the market?
We can also avoid transaction fees by matching up our brokerage house with our fund. If you have an account at Vanguard, buy low-fee Vanguard funds. If you have an account with Fidelity, invest in Fidelity’s Spartan Index Funds.
These may seem like minor changes, but in the end, they can make you some major money.