Who might be happy after a stock market crash?

By the end of this Insight, you’ll understand more than most people about this important paradox of investing.

In short, you’ll know why stock market crashes can (simultaneously) be good news for some people and miserable for others!

We know that sounds impossible, but it’s what sometimes happens in the real world.

So, it’s essential to understand this – and the thought experiments outlined here are the safest way for you to learn.

Imagine three different Investors

Robert, Grace and Ian are three fictional investors whose experiences we’ll explore:

• Robert was thirty-five when he started regularly investing £2,000 a year to build a fund to help his child through college.
• Grace was thirty-nine when she invested a lump sum of £20,000 for growth towards a college-fund goal for her children.
• Ian was approaching retirement and, among other investments, had a pension fund worth £100,000 – from which he withdrew a level income of £7,200 each year.

These three investors put money into the same investment fund for ten years and were surprised (or shocked) by their different investment outcomes.

We’ll explain why in a moment, but we first need to say something about their investment fund.

Imagine our investors all chose the same Investment fund

The best way to illustrate this paradox is to keep things simple.

We’ll assume all three of our investors put their money into the same (stock market based) fund – one that invests in the shares of a wide range of companies from many industry sectors in countries across the world.

This could have been a world-index-tracking fund, or an actively managed fund – but that feature doesn’t matter for understanding this concept.

We only need to know that the Investment fund behaves like most well-diversified stock market funds. So, the fund price might rise or fall (by a lot) in the short term, but it would likely* deliver returns ahead of savings accounts over ten years or more.

To be clear, we’re not suggesting that each of these investors should invest in the same type of fund.

Choosing a suitable investment depends on many things about you, your circumstances, and the nature of your financial life goals.

We’re simply pointing out the paradox of investing for different needs during different stock market scenarios.

*A warning about our example returns

The ten-year average return (7.2% p.a.) in our examples is provided purely for educational purposes.

It’s a reasonable (net-of-charges) number to assume when compared to historical averages, but it is not a forecast of future returns.

When investing, always read this warning and take professional guidance or advice when you can.

Past performance is no guide to future returns.

The value of investments and the income from them can go down as well as up.

You could get back less than you invested.

All investments should be regarded with a long-term view.

Also note that in the examples below, the returns:

1. Are not adjusted for inflation
2. Take no account of taxes, which may not apply in some cases.
3. Are assumed to be net of all charges (for the financial product and any advice)

Ask your financial adviser (or product provider) for illustrations of potential returns on any specific Investment-based product you’re considering – or currently hold.

Now, let’s look at our two scenarios.

Imagine two paths for the price of the Investment fund

You need to know how our three investors’ emotions might differ depending on the (up and down) price path of their invested funds.

Of course, the fund price could follow any one of millions of paths over ten years – and we could show how other price paths might affect the returns experienced by each investor.

For now, however, to help you grasp this concept, we’ll start by exploring just two very different scenarios.

Scenario 1 – Boom and slow growth

For this scenario, we’ll imagine the investment fund price initially flying up like a rocket ship, rising by 50% in the first year.

Then, after that price boom, the price growth continued at a slower pace of c.3% a year for the following nine years.

We chose this price path because it delivers an average return of 7.2% p.a. over ten years.

And that growth rate, if you know the ‘rule of 72′, will double the fund price from £1 to £2 per share over that time.

So, our ‘Boom and slow growth’ scenario would look like this:

Scenario 2 – Crash and strong recovery

For our second scenario, we’ll imagine the fund price crashes by 50% in the first year and then recovers strongly to grow at nearly 17% p.a. over the following nine years.

So, our ‘Crash and Strong Recovery’ scenario looks like this:

Note that this price path also doubles the fund price over ten years.

So, in both our scenarios, our investment fund delivers an average return of 7.2% p.a. after charges over ten years.

Wait, surely these are just simplified scenarios?

Yes, they are.

We’ve deliberately ignored the likely small and regular gyrations in the fund price to keep these examples simple.

Small daily price wobbles don’t significantly affect your investment outcome compared to the significant price shifts in our examples.

Also, while these examples may seem extreme, they’re not unrealistic. Even worldwide diversified stock market based funds experienced two falls of c. 40% (and another of c.30%) in recent decades.

Just remember that such funds also delivered better returns than cash deposits over that time.

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

To be clear, we’d never suggest that anyone would be happy with the extremely difficult times that may be associated with a serious stock-market crash.

The dot.com crash in the stock market (between 2000 and 2003) was different in this regard, but crashes are often associated with widespread job losses, wages failing to keep up with inflation, falling home prices and high interest rates on mortgages and other loans.

And the experience for Grace, if a recession had forced her to encash her investments early (or Robert, if he were unable to continue paying into his regular investment plan) would be very different to what we show here.

We therefore assume that our three investors did the wise thing – and built a substantial fund of accessible bank deposits – to use in an economic or other emergency (like substantial repairs to their home or their car) before they invested.

In this Insight we just want to explore which of our investors might be happy, upset, confused or indifferent about their investments in these two very different scenarios.

Before reading further, jot down the answers you’d put in these boxes?

Now, let’s look at the answers.

First – during the boom and slow growth scenario:

Robert (our regular investor) would initially be elated as he sees his first year’s investment grow in value by 50%.

However, over time, he may become frustrated by the slow growth of his accumulated funds. And, after ten years, his effective rate of return on all his regular investments would be just 4.2% p.a.

So, while Robert would have made a positive return, his accumulated fund after ten years won’t be much more than he paid in.

And after such a great start, he might wonder what had gone wrong with his Investment plan.

Of course, nothing went wrong. It’s just that after the first year, Robert’s subsequent investments only grew at 3% p.a.

Here’s how his fund values would have grown over time.

Grace (who invested a lump sum for growth) would be thrilled initially – as she sees her entire investment grow by 50% in the first year. And she, too, might be slightly disappointed at the reduced pace of fund growth in subsequent years.

However, Grace would have good reason to be happy throughout the journey and at the end of 10 years.

After all, she would not have endured the pain of any falls in her fund values and would have enjoyed an average return of 7.2% p.a. on her money – the same as that on the fund.

As for Ian, our Income investor, we believe he’d be delighted, and here’s why.

Ian might have expected the original value of his pension fund (of £100,000) to be preserved.

Remember, he withdrew 7.2% of his original pension fund for income at the end of each year, and his investment fund price grew (on average) at the same percentage rate each year.

Yet, Ian would have a pension fund value of £116,500 after ten years, and that’s nearly 17% more than he expected!

Taking account of his withdrawals, Ian’s experienced rate of return on his pension would have been 8.3% p.a.

So, a boom and slow growth scenario might feel like magic for an income investor like Ian!

Here’s how Ian’s fund values would look over our ten-year period.

Note how the initial 50% boost to Ian’s fund left him with more than £140,000 after his first income withdrawal of £7,200.

That initial boost to his fund made Ian’s (fixed) income withdrawals sustainable despite only modest fund growth after the first year.

What about the crash and recovery scenario?

In our second (crash and recovery) scenario, Robert (our regular investor) may be unhappy, initially, to see the value of his first year’s investment down by 50%.

Over time, however, Robert would be much happier about his returns, provided he could continue making regular investments.

And, after ten years, he’d be delighted to learn that his overall rate of return on all his investments was nearly 15% p.a.

Fifteen percent annual returns may sound incredible considering that the fund price only grew at an average rate of 7.2% p.a., but it’s simple to explain.

Nine out of ten of Robert’s regular investments would have benefited from the recovery period’s stellar returns of c. 17% p.a.

Here’s how his fund values would have grown over time.

Grace (our growth investor) might be even less happy than Robert after the first year, given that her entire investment of £20,000 would have fallen in value by 50%.

Please note that this sort of crash in stock market prices can cause severe stress for many people. And some will decide to take their money out of investments after the crash.

So, as well as considering your capacity to take investment risks, you need to consider your attitude to investment risk – also called your investment risk tolerance. 

In short, before you invest, learn about your temperament – and think about how calm you could remain during a stock market crash.

Many do well to take advice on this matter.

Assuming that Grace had been well advised and was in a position to hold onto her investments in this scenario, she too would end up happy, having doubled her money over the ten years.

And, as before, Grace’s experienced return on her investment would have been the same as the average (7.2%) annual return on the fund.

What about Ian, our income investor?

Well, sadly, Ian will likely be miserable throughout his investment journey in this ‘crash and recovery’ scenario,

Why?

As before, Ian might have expected to see his capital preserved (at £100,000) after ten years.

(His fund price ‘averaged’ a return of 7.2% p.a., and he withdrew the same percentage of his initial investment each year.)

Unfortunately, that’s not how this works – and unlike the first magical early-boom example, this second (early crash) scenario is horrible news for Ian.

After taking his fixed income for ten years, he’d be left with just £41,700 in his pension pot.

That’s less than half of what he started with!

Here’s how his fund value would look over time.

When we factor in Ian’s income withdrawals, his experienced return rate now would be just 1.8% p.a.

That’s more than 5% a year less than the average return on his investment!

So, in this scenario, Ian might reasonably view his income withdrawal pension investment as a disaster.

That said, his experience could have been even worse.

If we assumed the fund price recovery had been weaker (only recovering to its original £1 price by year 10), Ian’s pension pot would have been empty before year 10 – as shown here.

The bottom line on Investment price paths

We’ve covered a lot of ground in this Insight – so here are the key learning points:

1.  Your personally experienced rate of return on an investment plan can vary (quite a lot) from the average annual return on your investment funds over time when you are:
   • Contributing regularly to an investment plan.
   • Taking withdrawals from an invested sum.
2. Only when investing a lump sum for growth should you expect your experienced rate of return to be the same as the average annual return on your fund – after charges.
3. As you approach an investment goal (like retirement), you may have two investor situations running – with a substantial fund invested while you continue making regular investments.
   • If you don’t have much flexibility (on the amount or timing of your investment goal), you could consider a different investment approach to protect your existing fund holdings while still taking advantage of higher growth funds on your regular investments.
   • Most investment and pension product providers allow you to do this, but please seek competent guidance or advice for your unique situation.
4. Investment funds with the potential for very high returns may occasionally fall heavily in price – and big price fluctuations can seriously affect your experienced investment returns.
5. If an investment fund price rises quickly before levelling out:
   • An income-seeking investor may enjoy a magical return.
   • But, a regular investor’s returns may be lower than the average return on the fund.
6. If an investment fund price crashes early on and later recovers:
   • An income-seeking investor who needs to withdraw money from that fund might seriously deplete their funds.
   • This problem is known as ‘sequence risk’ – because it’s the order in which the fund price rises or falls that matters.
   • And if the fund price recovery is slow, there’s a risk of fund exhaustion if the income withdrawals continue.

Next steps

If you need (or will soon need) to draw income from your money, be sure to consider all your income-generating options very carefully.

And don’t forget to consider annuities in that assessment – as those products guarantee an income stream for life.

Take care with Investment fund selection on any monies that will remain invested.

It is not simple to generate a sustainable income from invested funds – so take guidance or advice in this area.

The challenge when discussing the price of investment funds (or homes!) is that young and old often hope for different outcomes. And we sometimes forget that asset prices don’t only go up.

So, be wary of investment advice from anyone without relevant qualifications or who relies heavily on their experience (or recent past performance) of investing or home-owning.

Your investment returns could be very different to theirs and will depend, as we’ve seen, on the price path of your investments over time.

To learn more about these risks and how to manage them – and for Insights on a range of other money questions, sign up for our newsletter below.

And please, contact a competent financial planner or coach if you require guidance or advice tailored to your unique circumstances.

Thanks for dropping in

Paul 

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