My Favorite Lesson From The Market Crash

by mfd on May 5, 2009

A lot of people will be looking at this market crash in the years to come and remember the great buying opportunities, but not me. I remember when this whole mess started, I was holding my Bank of America stock which I bought at a 10% discount and was ready to make out like a bandit. Well I didn’t and the market started its slow descent south (before falling off multiple cliffs). I would sit there and think to myself  “Well it can’t get worse”.  As we have all learned, yes it can. This is the lesson I’ve learned, “The markets/stock can always get worse”.

Why is this lesson important?

During bull markets people develop a sense of euphoria.   They seem to forget that there is risk associated with equities and begin to take unnecessary risks. They focus on the infinite upside and ignore the finite bottom. However, all bull markets come to end and that’s when the lesson comes into play. One day the market/stock will drop 5% and they’ll buy more stock. The next day it will drop another 5% and they’ll buy even more in hopes of doubling their money. Of course on the third day it ends up dropping another 5% but at that point they’re all out of money so they buy using leverage. The stock continues to drop while the investor sits there saying to themselves “well it can’t get any worse”. It’s this reason that so many retiree’s got caught in the crash because they assumed it things couldn’t get any worse.

Now as a young investor knowing just how bad the market can get is a sobering experience. You just can’t get that kind of experience from reading about past crashes. With most of my investing life ahead of me I feel I’m better equipped to make my investment decisions:

  • If I’m considering buying a risky stock I do it knowing that things can always get worse.
  • If I decide to apply for leverage to invest in a down market I do it knowing that things can get always worse.
  • When deciding my age appropriate asset allocation I do it knowing that things can always get worse.

Well if things can always get worse then why invest?

This lesson isn’t a testimonial to not invest or sell at the first sign of trouble. The market is still the best place to grow your money but you need to have a plan with proper risk analysis. If your only risk analysis is “Well things can’t get that bad” then you shouldn’t be in the market. Invest knowing that the market can potentially drop by 50% or more and account for that potential scenario both financially and emotionally. Once you’ve done that then you’ll be fine.

Now I just need to keep this lesson fresh in my mind because in 20 years this whole thing may not have seem so bad and I could open my self up to more risk. Any suggestions? Maybe getting it tattooed across my knuckles?

-mfd-

{ 7 comments }

Alexandra Macqueen May 5, 2009 at 11:14 am

“slobbering” – or sobering? ;)

mfd May 5, 2009 at 1:19 pm

doh! fixed now. Thanks :D

Dividend Growth Investor May 8, 2009 at 8:06 am

I guess the lesson learned is: do not invest with money you can’t afford to lose.. Don’t bet the house on the stock market..

mfd May 9, 2009 at 10:45 am

hi DGI,

The thing with “The markets/stock can always get worse” lesson is that in encompasses so many aspects of personal finance. Like the ones you mentioned and other things like asset allocation or “catching a falling knife”. It simplifies all these things when making personal finance decisions especially since people have short term memories and only focus on the upside of things.

Silicon Prairie May 9, 2009 at 10:59 am

If you’re investing for the long-term, it’s not really a big problem if a stock or index keeps going down after you buy it – it does make sense that if the price just got better you would want to buy more and no one can hit the bottom precisely. If you put all your cash in on a slight dip in an overvalued stock it’s not likely to gain you much but it’s still better than investing before the drop. It would be even better to monitor the situation over time, and if something is overvalued slowly increase your investments as it comes down.

I think the bigger lesson to remember is that when the majority of people agree on something they’re wrong (especially if they’re acting on it). It’s true that stocks can always go down further, but when everyone starts to expect the second consecutive 50% decline it turns out that the market has no more room to go down (for now) because there’s already been too much selling.

mfd May 9, 2009 at 11:19 am

Hey Silicon Prairie,

I totally agree with what you’ve said. The lesson isn’t meant to focus on market timing. The problem with people when they invest is they have a tendency to be too optimistic or over confident. By remembering that “the market can always get worse” adds a bit of pessimism and in turn can keeps people grounded.

Look at all these retiree’s who lost money because of the crash. I bet a majority of them know about asset allocation but they were too focused on the bull market. I’m sure plenty of them thought “well I’ve made X% return if I just leave my money in all equities for another year then I can retire even more comfortably”

Had they stopped for a second and remembered that things can always get worse then they would have paid closer attention to their asset allocation.

Silicon Prairie May 9, 2009 at 2:54 pm

It’s interesting to remember that some people take a small pullback in a bull market as a sign to buy more – that’s certainly one way to take good advice the wrong way. On the other hand when the whole index goes below the long-run trend it’s a much better picture.

It is always good to remember the potential for changes if you have a shortening time horizon. Now a lot of people will probably keep their money in stocks because they want to get back to a certain point and then get out – which might just take 10-20 years.

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