On Monday in Gravity – The Stock Market’s Mortal Enemy I raised the prospect that 2014 may be a reversal of the spectacular gains the market produced in 2013. Today I’d like to extend this discussion specifically to small investors – which is most of us – since they seem especially prone to get clobbered in bear markets, much more so than large investors.
If small investors are following the preferred investment handbook – buy-and-hold, dollar cost average, etc. – why do they seem to fare worse than large investors in down markets?
I think there are whole bunch of reasons why this is true and it has to do with factors that are well beyond the scope of investment theory. It’s easy enough to see the wisdom of theory when we’re riding high. But when things begin to get ugly, panic sets in and theory goes out the window. There are all kinds of reasons why small investors are more vulnerable to this than large investors are.
Small investors have more to lose
If you have a $5 million stock portfolio and the market takes a 50% haircut, your holdings are down to $2.5 million. You have 50% less in your portfolio than you did before, but you’re still a millionaire!
If you have a $50,000 stock portfolio and the market takes a 50% haircut, your holdings are down to $25,000. If you need a minimum of $4,000 per month to pay your bills, that drops the value of your stock portfolio to that of a six-month emergency reserve.
These are the kind of numbers that illustrate why a small investor is more likely to panic sell at or near the very bottom of a bear market or crash. While the large investor has the luxury of thinking strategically – after all, he still has a lot of money to play with even after the decline – the small investor may be forced into survival mode. This is not a matter of ignorance, but the recognition of necessity.
Following the herd
Since most small investors are relatively new to the market, they’re much more prone to following the herd. There’s a fundamental problem with this – the herd tends to buy heavily at market tops, and sell out at market bottoms.
Once again, from a theoretical vantage point, this makes no sense at all. But it’s just one example of how theory goes out the window in market extremes. In fact, that herd mentality contributes mightily to stock market bubbles and stock market crashes alike.
Herd mentality is not rational, so there’s no way to comfortably wrap it neatly within investment theory.
Greed at the top of the market, fear at the bottom
Whenever we get prolonged bull markets, greed begins to kick in. It’s no longer about sound investing – it’s about getting rich. For this reason, small investors in particular can throw caution to the wind, and load their money into the stock market.
The process becomes self-reinforcing as double-digit returns produce immediate impressive gains. At this point, valuations don’t matter and neither does common sense. Market exposure increases, and as it does risk rises exponentially. The small investor is piling in at the very time he needs to pare down.
The flipside occurs in bear markets and crashes. The fear of losing everything takes over, and the small investor sells at the very time it would be most profitable to begin buying.
Worse, since he took such a big loss in the market decline, he’ll be hesitant to return to the stock market at the very time he most needs to be buying in. He will probably wait several years until the market confirms that it is “safe” to begin investing again. He will leave substantial gains on the table as a result of this delay.
This is where large investors tend to be strongest. Despite impressively large stock portfolios, they usually have equally large positions in other investments. This can include fixed income investments, such as certificates of deposit and Treasury securities – which are also essentially risk free – as well as investment real estate, commodities and significant business interests. Even if the stock market crashes, a large portion of their wealth is invested elsewhere.
This is usually less likely with small investors. Since investment capital is limited, small investors tend to put most of their money where it has the potential to provide the greatest return. During bull markets, this is certainly the stock market. This is also why small investors tend to over-invest at stock market tops, and get clobbered in the process.
If a large investor has 50% of his money in the stock market, and the market drops 50%, his overall portfolio will decline by just 25%. By contrast, if a small investor has 90% of his money in the stock market, and the market drops 50%, his overall portfolio will decline by 45%. Given that he has less capital to begin with, the small investor could be facing a truly catastrophic financial situation.
The Lottery mindset
Lottery tickets and wealth exist in inverse proportions. The poorer you are, the more likely you are to buy lottery tickets. In fact, the lottery has sometimes been referred to as the poor man’s dream.
Investing in the stock market is a rational process up to a point. But beyond that point there’s little difference between putting money into the stock market and buying lottery tickets. You’re hoping against hope to get rich, even though the fundamentals don’t support it.
That’s what happens at market tops. Though people believe they are investing in the market, they’re really speculating. There is a point in every bull market where the entire process becomes blatant speculation. Valuations no longer matter – it’s an exercise in the greater fool theory (buying a questionable investment with the expectation of selling it later at a higher price to an even greater fool). Because of the herd mentality, small investors seem to be especially prone to this.
What’s a small investor to do?
As a small investor, what can you do to avoid getting clobbered in bear markets or crashes?
Watch – but don’t join – the herd. The herd is dangerous when you are running with it. But it can be quite valuable when you observe it from afar. By this I mean if you watch what the herd is doing, you get a pretty good idea as to where the market is at. If the majority of people are buying – and have no real sense of danger – it’s a strong indication that the market is at or near a high. That’s when it’s time to reduce your positions. If the majority of people are avoiding the stock market, sensing doom and gloom, that’s the time to be buying stocks, and doing it aggressively. Watch the herd, and do the opposite.
Stop thinking that the stock market will make you rich. Investing in the stock market is a process, a very long one at that. Recognize that there will be ups and downs, and that the market will rarely cooperate with your plans and dreams. And invest accordingly.
Get serious about diversification. I realize that many investment advisers and investment models recommend that young people put 80%, 90% or more of their portfolio in the stock market, and I understand the reasons why. But that’s a poor diversification. It works extremely well in rising markets, but it’s an absolute disaster when they fall. A substantial amount of your money needs to be in investments that have nothing to do with stocks. If they aren’t, you’ll be very vulnerable to a bear market or crash. Simply diversifying between different stock groups is not a sufficient form of diversification. Diversification is what enables you to weather a stock market storm, and have cash at the bottom when you need to be buying. Don’t skimp on this step.
See the stock market as one component of your overall financial plan. It can be emotionally comforting to believe that the stock market will be the elevator ride that takes you up past all of your current financial challenges, but it’s unlikely to work that way. Properly managed, your stock market investments should be one component of your overall financial plan – an asset in your life’s financial “portfolio”. That means that even if the stock market is booming, you still need to concentrate on your career or business, to maintain proper insurance coverage, to build significant non-stock market investments, and keep your living expenses in check. If all of these are where they need to be, you’ll be in a better position to manage a bear market or crash in stocks.
Bear markets and crashes are NOT aberations. During bull markets there’s a tendancy to dismiss serious market downturns as historic events. They’re not. They’re part of the game, and you need to accept it and be ready for it. In the past 30 years there have been three significant crashes, and at least as many bear market phases. Though the bear markets have been relatively short during that time, a bear market that began in 1966 lasted until 1982 – 16 years! Nothing is guaranteed in the stock market, no matter what current trends seem to indicate.
Bear markets and crashes are a fact of life in the stock market. It’s not the fact that they happen that’s most important – but how we prepare for and react to them. They should be seen as opportunities, not calamities.