Who might be happy with a stock-market crash?

Today, I want to explore how stock market crashes can make some people happy and others very unhappy – both at the same time.

I’ll introduce you to Robert, Grace and Ian – three fictional investors who all invested in the exact same fund for the same ten years… and yet experienced very different outcomes – and emotions along the way.

Sounds crazy, right?

Yes, but this is exactly what happens in real life.

And despite being one of the most important concepts to grasp about investing, it’s one of the most widely misunderstood.

So, if you or any of your friends are investors, you really do need to understand this.

The crazy idea in a nutshell

So, how could one investment fund, over one period of time, possibly cause one person to be happy whilst making another very unhappy… or even IRATE®?

Well, if you have a financial adviser/wealth manager, you can ask them to confirm what I’m saying. Or, if you don’t have an adviser, just ask someone else who really understands personal finance to confirm these facts – because that’s what they are – facts.

To explore this, let’s look at our three different investors:

• Robert makes regular investments of £2,000 a year – to build a fund to help a child through college.
• Grace invests a lump sum of £20,000 (or already has it invested) for growth towards a similar, college-fund goal – and
• Ian has a pension fund worth £100,000 from which he plans to withdraw a fixed income at the rate of £7,200 p.a.

All three of our investors want to know how they might feel during their investment journey over the next 10 years.

Now think about an investment fund

All three of these investors opt to invest in the ‘S’ (for Super!) fund 😊- which is a typical, broad-based fund of shares in companies from various industry sectors from various countries.

Our imaginary ‘S’ fund might be a world Index-tracking fund or it could be an actively managed fund. It might even have an environmental or ethical filter.

But these features don’t matter for the purpose of understanding this concept. All that matters is that the fund contains typical (worldwide diversified) levels of stock market risk and potential reward. So, the fund price could rush up (or down) quite quickly over short periods of time.

Finally, imagine two fund price journeys

To explore how our three investors’ experiences might differ, despite them investing in exactly the same fund over the same period of time, consider two different investment scenarios.

Scenario 1 – the fund price booms and then slows but continues growing

In this scenario, the fund price flies up like a rocket ship, rising by 50% in the first year. The fund price then levels off to grow steadily at c.3% a year over the following 9 years. That produces an average return of 7.2% a year.

This, if you’re familiar with the ‘rule of 72′, will take the fund price from £1 per share to £2 per share – over the 10-year period.

We’ll call this ‘boom and slow growth’ scenario and it looks like this:

Scenario 2 – the fund price crashes but then recovers strongly

In this scenario, the fund price crashes, falling by 50% in the first year. It then recovers steadily and strongly, growing at more than 16% p.a. over the following 9 years to give the same average return of 7.2% a year over the 10-year period.

We’ll call this the ‘Crash and Recovery’ scenario and it looks like this:

OK, but aren’t these simplified and extreme scenarios?

Yes they are and I’ve deliberately left out the likely small and regular oscillations in the fund price to keep this Insight simple.

You see, small day-to-day, even month-to-month fund price movements don’t make a huge difference to your investment outcome compared to much bigger, longer-term price shifts.

That said, I have used more complex, realistic jagged line examples in my book, Who can you trust about money? 😉 and in an article, I wrote for ‘Investors Chronicle’ some time back.

So, if you prefer more complexity, try that but be aware that this Insight covers more concepts than I covered in the IC article. So, you might want to stick with this one.

Also, whilst these examples are somewhat extreme, they’re certainly not unrealistic. Just look at the three crashes of 30% to 50% that we’ve had on world stock markets over the past 20 years for evidence of that.

These examples are also not as extreme as they could be.

When stock markets fall by 50%, they don’t always recover as strongly as I’ve shown in scenario 2 here.

Look at the Japanese stock market after 1989 for evidence of that.

Also note that to keep this super simple, I’ve assumed that the investment returns are net of all charges – for advice, investment fund (management and product wrapper) and any investment platform you use.

Charges can destroy large slices of your investment returns if you’re not careful. So make sure that you don’t pay unnecessary charges.

Who might be happy (or upset) in these scenarios?

Right, so getting back to our main story, who, of our three investors, would be happy (or upset) about their investments at various times, in these two scenarios?
Well, here’s how I think they’d play out.

In a boom and slow growth scenario

Robert (our regular investor) would be happy initially – as he sees his initial investment input grow very fast from that boom in the fund price.

However, over time, he’d likely get frustrated at the slowing progress of his fund growth. And, after 10 years, the equivalent (smoothed) return on his money (his ‘internal rate of return’ or IRR) would have slowed to just 4.2% p.a.

That’s 3% less (every year) than the average annual return on the fund 🙁

So, Robert would likely wonder what went wrong after such a great start.

The truth is that nothing has gone wrong here. It’s just the nature of regular investing: your experienced return, your IRR, is reduced (compared to the end to end performance of the fund) when the fund price follows this initial boom type of shape.

Grace (our growth investor) would be extremely happy initially – as she sees her entire investment grow by 50% in the first year.

And whilst, possibly, disappointed at the reduced pace of fund growth in subsequent years, she’d probably still be happy throughout the journey and at the end of 10 years. After all, she’d have seen no losses and ended up with an equivalent (smoothed) IRR of 7.2% p.a. on her money – the same as the average annual return on the fund.

But what about Ian, our Income investor?

Well, I’m quite sure that Ian would be the happiest of them all – and here’s why.

He might have expected to see his capital intact (at £100,000) after 10 years – given that his fund price ‘averaged’ a return of 7.2% each year – and he withdrew 7.2% p.a. each year for income.

And yet, after 10 years, he’d have had £116,500 in his pension pot 🙂

His IRR would have been an incredible 8.32% p.a. – over 1% a year more than the ‘end to end’ annual performance on the fund.

So, investing would be seen as pure magic to Ian.

Interesting?

OK, but what about the crash and recovery scenario?

Well, as you might guess, the happiness fortunes get somewhat reversed when the fund price takes a markedly different path – despite the end-to-end return being exactly the same as the boom and slow growth situation.

Remember, in both scenarios our fund price doubles over 10 years – giving an average annualised return of 7.2%.

In this second scenario, Robert (our regular investor) would be very unhappy initially as he sees his initial savings crash in value along with the crash in the fund price.

But then, over time, provided he’s able to maintain his regular investment, he’d become increasingly pleased with his investment plan statements.

And, after 10 years, his IRR would have recovered to an amazing 14.75% p.a.

Yes, seriously.

That’s what happens if crash early on in a regular investing journey – provided that they recover thereafter. Your returns can be quite spectacular.

Grace (our growth investor) would also be extremely unhappy initially in this scenario – as she’d have watched her entire investment crash in value by 50% in the first year.

And it’s worth noting that for many people, that journey down is too much to bear. So they tend to pull their money out of investments as prices plummet. That’s what turns a market correction into a crash.

Of course, a growth investor who stuck with their investment in this scenario would end up happy. After 10 years, Grace would have doubled her money on that IRR of 7.2% p.a. – the same return as the fund.

But just remember – not all crashes are followed by such wonderful recoveries. When stock markets are very overpriced, they can go down and keep going down for long periods of time.

If you not done so already, look at Japan for a reminder of that.

But what about our income investor?

Well in the crash and recovery scenario, Ian is going to be extremely unhappy – and would likely have been very unhappy throughout his journey too.

Here’s why.

You see, as with the previous scenario, Ian might have expected to see his capital preserved (at £100,000) after 10 years. After all, his fund price has ‘averaged’ a return of 7.2% p.a. and he only took out 7.2% of his initial investment each year.

That’s just simple sums, right?

Unfortunately no, that’s not how this works… and in this case, after 10 years, Ian would be left with only £41,500 in his pension pot.

Ouch, that’s less than half of what he started with!

And, Ian’s ‘experienced’ rate of return would have been just 1.8% p.a. Yes, a whopping 5.4% each year, less than the average return on the fund he was in.

So, for Ian, an income withdrawing investment, in this scenario, would be seen as pure hell.

What’s more, if that recovery had been weaker – and brought the fund price back from 50p per share to, say, £1 (instead of £2), Ian would have run out of money completely – before the end of our 10-year period.

That’s horrendous if you need your pension fund to last for your lifetime.

Right, so let’s sum up

The investment returns you experience (your IRR) depend on how you invest – whether that’s by:

1. Making regular investments over time
2. Investing a lump sum for growth (with new monies or your existing holdings) or
3. Investing a lump sum (or using existing monies) to withdraw income.

Note also… As you approach your investment goal (e.g. retirement) you might have the first two of these situations running in parallel. And depending on your situation, you might want to adopt a different investment approach for your existing fund holdings to that you adopt on your future regular investments.

Most good investment providers will allow you to do this, but very few advertise the feature. So, if it sounds like it could be helpful to you – talk to your investment provider or adviser.

Only in the case of the lump sum investment for growth will your IRR be the same as the average annual return on your fund net of charges.

Regular investing and income withdrawal plans might, in theory deliver IRRs that are the same as the average return on your funds. But only if the fund follows a perfect geometric growth curve – and that’s very unlikely 🙂

A fund price that ‘swings around’ a lot can have a big effect on your experienced investment returns.

A fund price path that boosts the returns for a young regular investor could deliver a horrendous experience to their parents looking for income.

A regular investor, in this scenario, benefits from something called ‘Pound/Dollar-cost averaging’ – whilst the income investor gets hurt by something called ‘Pound/Dollar cost savaging’… and that ‘early fall’ scenario poses a serious risk of fund exhaustion to pension income investors as we saw here.

Conversely, if the fund price follows a different path – rising first before levelling out – the younger saver’s returns might be reduced by quite a bit – whilst the income investor might enjoy a magical return.

So, as with home prices, the young renters and older homeowners hope for different things to happen.
And that’s worth remembering when the older folk insist that you need to ‘hurry’ to get on the property ladder. Home prices are not a one-way street of ladders. They’re a game of snakes and ladders.

Advice from folk with past experience of investing (or home-owning) should be treated with caution. Your experience could be very different and will depend on the price path from this point in time.

Where will stock markets head from this point in time?

I have no idea – and nor does anyone else.

That said, on a valuation basis, by historical standards, we know that the world’s largest market (the USA) is looking overpriced. So, whatever anyone tells you, there is a chance of a steep fall from here and you might want to factor that into your planning.

I covered the four factors to consider around risk on any investment here.

Thanks for dropping in

Paul

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