Facing your Fear of a Financial Market Free-Fall

As investors, there are two things we absolutely love – appreciating asset prices, and / or greater income from those assets. And boy have the past few years been good to us – especially for our friends in the US!

But all this Fortune brings with it a potentially Frightening downside – the Fear of a Financial Market Fall – or CRASH! Yes, these do happen occasionally, and can really put a dent in your Fund balance.

Yes – this does happen unfortunately…

Given this Fantastic run over the past Few years, the media is Full of speculation around if and when a potential downturn might be coming. Seems like a timely issue to address as we get Frankie’s Fund up and running.

If you’re Fully retired from work and Fully rely on Fully-Franked dividends from your own Fund for your survival, then this rollercoaster ride might cause you a little grief. You’d likely have a more diversified asset base outside of shares to smooth the ride in these circumstances, but that’s a discussion for another day.

However, if you’re relatively young (yes that includes Frankie at 40!), you’re most likely still an accumulator of assets. Which is a wonderful thing, as it means with the right perspective and strategy, you can learn to love the opportunities this rollercoaster ride can bring…

It’s only a ride…

I used to hate rollercoasters, or any rides that lifted you more than 6 feet off the ground. I had a debilitating fear of flying through the air at such a height. But some years ago, I faced these fears, and slowly but surely, I’ve become a serious rollercoaster junkie! The more extreme the better!

It’s not something you can easily rationalise to yourself. You just have to get accustomed to the Feeling. And when you do, your perspective changes from one of crippling Fear to sheer joy!

The stock market is a little similar, although more like a rollercoaster ride in extreme slow motion – riding a few big ups and downs over decades, rather than minutes. With the rollercoaster, you also end up right back where you started, no matter how long you ride it for. The stock market, on the other hand, continues to climb higher over the long-run – eventually.

But when it comes to investing in shares, it’s not just about the thrill of it all…

Stocking up

I’m one of those people that seriously stocks up on sale items at the supermarket. It pains me to pay full price for anything!

You’ve probably heard the supermarket sale analogy for buying stocks when prices fall. Most of us can relate to the analogy of buying goods on sale for three big reasons:

  • You can generally understand the ‘regular’ or Market price and the discount you’re getting (supermarkets usually point this out in big bright labels!)
  • The discount usually lasts for about a week – and again, the supermarkets spare you the need for fortune telling by telling you the prices will go back up afterwards
  • Most of us don’t have much trouble Finding extra Funds to stock up on groceries we will use

This is a Fantastic starting point to for thinking about Falling stock prices – you’re just buying the same shares at a lower price! Bargain!

However, you have to be a little careful translating this analogy into the real world of shares…

1) How much is the actual ‘discount’?

We’re used to thinking that when prices fall, that means what we’re buying is cheaper, and we’re getting a better deal. This is true for things like groceries and supplies that pretty much stay exactly the same before and after the sale.

However, shares of businesses can be a little different. Just because the price of a stock falls, doesn’t mean it’s cheaper – it might mean something has happened to the business (or expected to happen) that has made it truly worth less.

This is where bargain hunting in the stock market is tricky. The value of a business is much harder to get a handle on. There is no perfect representation of value, no ‘right answer’ – only opinions.

There are skills you can learn that can help you understand the value of a business much better, but be aware that it’s not as simple as doing a few quick calculations. There’s an art to estimating true value well, and experience is critical to interpreting any facts and figures in a sensible way.

Of course, your ‘F’hilosophy of markets might be very different to mine. You may believe that the price always reflects the most accurate value of the business, that markets are super-smart, rational and perfect. In that case, none of this will matter to you! The price is always right!

If however you think more along the lines of Frankie’s ‘F’hilosophy, that markets sometimes do silly things (markets are just a bunch of emotionally susceptible humans buying and selling after all), then understanding value is a critical skill.

But let’s say you’ve become a master of valuation, and can identify discounts in mere seconds with your super-human stock analysis skills. It’s that all there is to mastering market crashes?

2) What should I buy?

There are products we use, and will continue to use, for months and years to come. For example, if my favourite toilet paper is 50% off, it’s an easy decision to load up on a few rolls.

But what do you need to buy from the stock market when there’s some heavy discounting going on? Are you a sucker for any big discount on new items, or are there specific businesses you’d love to own a piece of?

And back to point 1, do you understand the business well enough to know what the ball-park discount is likely to be (if any?).

Ok, you’re a master business valuer, and you’ve identified the stocks you’d love to own a piece of if they truly went on sale. The next big question is…

3) Do I have Funds to stock up?

The Funds required to snap up groceries on sale are usually pretty small in the scheme of things. I suspect not too many people worry about having a ‘grocery sale emergency fund’ or stress about how they’ll pay for those 10 boxes of tissues at 70% off they desperately want to take advantage of.

Stocks, on the other hand, involve decent chunks of your capital. A little more planning is usually needed to prepare for share ‘sale’ opportunities.

Optionality vs steady stream

The value of having a pile of cash ready to spend is in the ‘optionality’ it provides. When prices plummet, you’re ready to pounce!

But there is a potential price to pay for this optionality (as always – no Free lunches!). The First is the opportunity cost of keeping those Funds in cash, rather than shares. You’ll be missing out on any potential upside. Your decision on this might depend on how much pain you feel missing out on gains vs seeing your shares drop in value.

The second big issue is when do you exercise this option? When the shares on your shopping list Fall 10%? 20%? 50%? How do you know whether to go all out now, or wait a little longer?

Patience

You’ll have seen with Frankie’s Fund that I have $50,000 to deploy, and I’m not planning to waste too much time leaving it all in cash.

Now patience has often been a weakness of mine. When I get the sniff of a great potential stock bargain, it’s very hard to resist going all in. To help manage this, my strategy is to keep as Fully invested as possible, and rely on my ‘operating income’ to Fund any new purchases (an additional $2,000 a month to my Fund from earnings).

This has two big benefits for me:

  • it prevents that anxiety of having cash sitting there, and waiting desperately for an opportunity to get it working harder for me; and
  • it takes the stress out of the timing decision for me. I have no idea if that 10% price fall is going to continue or not. If it does, I’ll have more Funds next month to keep buying. If not, then I’m happy to have taken advantage of a little dip.

There is a third option that some of you might be thinking about – a big, dirty, four letter word starting with D, which I certainly won’t be entertaining here…

A final thought on Peak Perspective

You’ll notice in the media that any decline in stock prices will almost always be with reference to the peak.

This is basically presenting the current state of the market in its worst possible light. Which of course is great for making scary headlines to get your attention.

Don’t let this Freak you out.

If ‘the Market’ falls 20% from here next month, you’ll see nothing in the media but headlines on the billions of dollars lost!

But don’t forget that even at 20% lower from here (if that was to happen), the All Ords Index would still be around 100% above where it was 20 years ago, 300% above where it was 30 years ago, or nearly 900% above where it started in 1980! And that’s after a ‘Crash’! That’s many, many more billions of dollars made! (and for our US readers, your returns are even better!). And the rollercoaster ride will continue to climb again at some point.

This might not be any consolation if you’ve just put all your life savings in the stock market prior to a crash. But if a scenario like that worries you too much, perhaps think about how to patiently allocate all those Funds into suitable investments over time.

Face your Fear – Carefully….

You can definitely Face your Fear of Financial Market Free-Falls, and overcome it. Even learn to enjoy the excitement it brings, like the rollercoaster.

But well and truly prepare yourself. If you lose your marbles on a rollercoaster, you’ll end up safely back where you started, no harm done (except maybe to the eardrums of your co-rider). If you Freak out in the stock market during a crash, you’ll likely harm more than just your ego.

 

What’s your strategy for preparing for a Financial Market Fall? Do you keep cash set aside, or Follow Frankie’s approach of staying Fully invested? Are you prepared to deal with a decline when it eventually happens?

10 Comments

  1. Frankie, The only time I was truly fearful was late 2008 and early 2009. All I can say is I hope we never go through that again in our life times. I’m pretty conservative with my assets and asset allocation but nothing could have prepared me for losing money like that. Tom

    • Frankie

      We can certainly hope, but it pays to expect the worst and be prepared. At least having gone through it you know what it feels like and can truly appreciate the potential risks. We had a bit of dumb luck around that time – we had sold a good chunk of our shares to buy our first home, and were able to start accumulating again a couple of years later (when we actually had some money again!). Even so, I’ve had a few mini-portfolio crashes with specific stocks in my time…

  2. I was super scared after 2008/2009. I was in cash ever since. I missed the huge rally in 2013/2014. Since 2016 I have been slowly investing in the market. Investing is inherently risky and I don’t want to increase my risk by picking individual stocks. So, I buy ETFs. I have tried t diversify and reduce risk. Not much we can do beyond this.

    • Frankie

      Sounds like a good strategy div geek – no need to stress yourself out more than necessary. Just got to do what works for you, and don’t look back in regret over any missed gains. We could all look at 100 stocks we ‘missed’ buying each year that made plenty of money!

  3. Fully agree with being fully invested. We simply can’t know what’s going to happen. The market can remain overvalued for a long, long time, and then when it does eventually drop, we’re probably still worse off for having waited.

    Interesting how the 2000s boom of the ASX looks really out of place in hindsight.

    Even in retirement, dividends are much more stable than share prices, which provides for a much smoother ride while the sh!t is hitting the fan 🙂

    Some cash in the bank to cover dividend reductions, flexibility in spending and possible side income should provide a good cushion the next time the bear grizzles.

    • Frankie

      Hey SMA – it’s really interesting to compare the ASX price above with the annual dividends of a group of stable dividend payers – I doubt you’d even notice a little bump around 2007 – 2009!

      You can’t know what’s going to happen – both on the way up, and the way down. Even if you ‘wait’ for the drop, how do you know when to start buying? The extent of the drop always looks obvious in hindsight…

      Here’s to hoping that cushion isn’t needed for some time to come yet!

  4. Just need to go in with a smart market strategy. The long term game will win every time. Like you mentioned, downturns are supposed to happen, its natural. But things will rebound and you will be rewarded for staying in the game. DRIP at lower levels and/ or buying quality companies at a discount that are built for the long term as well. Be patient, smart, and enjoy the ride.

    • Frankie

      Sounds like you have a plan Div Daze – just have to keep calm and stick to it. Let’s see what 2018 brings!

  5. Hi Frankie, I’m a first time visitor. I always seem to have some cash lying around for investment. So, it allows me to take advantage of any market dips. Looking back on the market declines in 2008/2009, I am happy to say I rode them out. I wasn’t too happy about the declines, but since I didn’t need the money anytime soon, I just stuck with my investing plan. In the end, I came out just fine. As I get closer to relying on my investments to fund my future (instead of relying on a job), I will reconsider my allocations to provide some additional safety.

    • Frankie

      Welcome Engineering Dividends, thanks for visiting. Great that you managed to ride out that horrible period and stuck to your plan. No-one likes to see investments going down any amount, let alone a whopping 50%! But staying disciplined, stomaching the drop, and having the means to keep accumulating usually works out for the best in the end. Good idea to revise your asset allocations if you’re planning to live off your funds soon – I’m a long way off considering a reallocation away from stocks at this stage!

      Good luck managing those extra college expenses this year! Hope your investments can produce some nice returns for you to limit the pain…

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