How to deal with market crash or sharp pullback?

market crash

Investors have a common problem

Most people are afraid of market crash or sharp pullback these days. As a friend on the blog, Willy, wrote over the weekend that the U.S. stock market has fallen sharply this year, and the money accumulated in the past two or three years has almost been lost, causing investors to lose confidence in the stock market. Therefore, he wanted to hear about my previous experience when I encountered a similar market pullback in the past, my state of mind at that time, and how I got through it.

Willy is not unique. Most investors have encountered such troubles. Because in the past three months, at least three friends have talked to me about the same troubles and constant anxiety it caused.

Many investors who cared about the stock market in the past have gradually given up tracking the market, have less time to care about the market, or have left the stock market. This can also be observed from the relevant page views of my blog.

Sharing my experience

The past three experiences

I myself have encountered three crashes in which the US stock market fell by about 40% (excluding the current one, because it will continue to bottom or rebound, no one knows):

  • My portfolio topped out around -30% the first time I was young and ended 2021 down 12%. The market crash triggered by the dot-com crash lasted about 2.5 to 3 years.
  • The second time was the financial tsunami and the subprime mortgage storm. When the market was at its lowest point, my investment portfolio fell by about 35%. At the end of 2008, my investment portfolio fell by 22%. The crash lasted about 1.5 to 2 years.
  • The third time was caused by the pandemic in 2020. When the market was at its lowest point, my portfolio fell by about 38%, and at the end of the year, my portfolio rose by 83%. The crash lasted less than three months.

For comparison, during the same three periods, Berkshire’s stock returns were negative 32.35% in 2008, negative returns for three consecutive years since 2000, and negative 20% from 2022 to the present.

I bought stocks in these 3 crashes

I choosed to buy the stocks I’m watching during these three crashes:

  • The first time I bought a few tech stocks in 2001, it looks like I bought it in the second half of the crash; I mentioned this story in the preface of my book “The Rules of Super Growth Stocks Investing”.
  • The second time I entered the market and bought Apple.
  • The third time I bought Microsoft, I mentioned how I chose and why I finally chose Microsoft in section 5-3 of my book “The Rules of Super Growth Stocks Investing”.

After these three purchases, the market continued to fall; especially Apple I bought in mid-2008 after market began to fall for about half a year, so it took a long time to return to the my purchase price.

Not forced to sell shares

It’s important to note that I never borrow money to buy stocks, nor do I go short. Therefore, even if the market falls badly, I am not afraid of receiving the margin calls. This actually has to be brought up, because if you borrow money to buy stocks, you have to live with being forced to sell your shares when the market is tough. As long as you are forced to sell stocks, it will end badly.

I have emphasized many times in the blog, especially retail investors should not try to short or borrow money, but very few people agree, especially young people almost do not agree.

During the bull market and the market is flat, investors are repeatedly advised not to borrow money to buy stocks, and no one will listen. But as long as you receive margin call, lose all your current positions, or even go bankrupt; you don’t need to persuade, just experience once, you will remember it for a lifetime.

On the contrary, I advise retail investors not to sell short, however, it is useless to say it again and again. But if in the bull market, has been squeezed. Preferably, the brokerage will be forced to sell out your account. You will remember for a lifetime!

Human nature of risk aversion and short-sightedness

Since human nature chooses to avoid risks, when faced with a crisis, the natural response of human nature is to choose the shortest or fastest solution at the moment and escape from the market.

Another investment behavior that affects most investors is too short-sighted. This is also human nature, and it is difficult to avoid it, especially now that information is disseminated rapidly, and orders placed on mobile phones can be completed immediately. One can immediately escape the struggles of human nature.

Most people only focus on short-term return, thinking of the return of last year, at most the year before. But short-term returns really don’t matter. “Investors should pay attention to the annualized rate of return (IRR), How to calculate?

The luck

Two examples

In the past 100 years, there have been two well-known periods in which the stock market has been at a low level for a long time:

The Great Depression began in 1929, and the Dow Jones index was 381 on September 3, 1929, and it did not return to 404.39 until 1954; a total of 26 years in the middle, you cannot imagine that the US stock market once had this history. Even Buffett has not been through this period.

On February 9, 1966, the S&P 500 hit a high of 94.06. Sixteen years later, on August 12, 1982, the index was only 102.42 points. Because it is the long-term inflation that lasted 16 years from 1966 to 1982. Economic growth is uncertain, inflation remains in double digits, and the stock market is chronically depressed.

Unless investors are very unlucky (no one knows this) and hit two long-term troughs of 16 and 26 years in 1929 or 1966, the stock market cannot keep falling, and the stock will always rebound if it falls enough. But don’t believe anyone who tells you that if you hit a certain number (Anone who clearly states a point in time or a number, you can be 100% sure he or she is a liar), it’s bound to come back up, because the stock market is more complicated than anyone imagined.

A high degree of uncertainty is the only thing stock market can be sure. For this part, please refer to my previous article “The uncertainty in Investing“. I wrote an article exactly a month ago “Does the stock market fall deep enough?“, you can take a look.

The past 3 years is not the market norm

In the past three years, the average annualized returns of the S&P 500 index of U.S. stocks were 28.88%, 16.53%, and 26.89%, which made everyone more attractive to enter the stock market. However, it attracts many people who have no concept of stock market investment to enter the stock market, expecting their funds to increase by 20% every year like the average performance of the stock market.

Please note that this sentence is wrong from beginning to end, because people assume these 3-years nubmers will repeat in the future, the sample period is just too short, especially for the stock investment activity need long term efforts. But most people think that in the past three years, these return numbers for the broader market prove that this is the average return on investment in the stock market. These returns were abnormal, as the S&P 500 has averaged an annualized return of about 7.89% since its inception.

If the investor only joined the stock market in the past two or three years, at the peak of the bull market, it is impossible to make money so far. Most people dump their stocks immediately, which is normal. Because at that time, it was assumed that there should be an average annualized return of 20% every year; since this has been the case for the past three years, it should be the same in the future. It seems impossible to achieve now. In order to avoid the loss, most people will choose to take profit early for safety.

market crash
Credit: BusinessInsiders

The importance of long-term investing

Long-term compounding is important

I use Buffett as a benchmark for comparison. When I was young, I didn’t know the power of long-term compound interest, the mystery of IRR’s long-term annualized rate of return, and the importance to investors.

No matter what kind of investment, value, growth, or large-cap ETFs, investors are bound to experience a once-in-a-decade crash. If the investor can survive the next crash, it is estimated that the investor’s overall portfolio return will be positive even at the bottom of the next crash (since roughly another decade of wealth accumulation has achieved, you should have more fund).

But if investors panic and dump their portfolios at the market bottom, the compounding interest that investors have spent so much money on over the past few years will be interrupted. When the market recovers and then goes back to buy, the price that investors buy is the price that has been inflated (the simple reason is inflation, see “Inflation and rate are the most two serious killers to investors“), this is the price figures that are easy to see on the surface are easy to understand.

But another side that few people think about carefully is that once compound interest is interrupted, it will never go back. The reason why many salary people can’t make money from investment is that they do dollar cost average at the high point of the stock market, but stop deductions in the bear market or market crash.

Such investment behavior will shorten the remaining time that investors can have for the accumulation of wealth–because “everything has to start from scratch“, just like a 20-year-old who has just entered the market, he has no experience in the stock market, but you have already loss of tested portfolio assets accumulated over the past few years. Twenty-year-olds do not have the funds accumulated in the past, which is the advantage of experienced investors over young people, but twenty-year-olds can accumulate wealth generated by time compounding for a longer period of time than you.

Reset and restart from scratch

Most people will dump their stocks when the stock market enters a bear market (down 20%) or crashes, or see that the holdings that made a lot of money have been shrinking, before it is about to turn into a negative return; At least until there is still profit, lock in the profit and sell all the shares, keep empty-handed, stand on the sidelines, and wait for the stock market to rebound. This is the practice of the vast majority of people, and it is very difficult for human nature to resist this practice.

Suppose the stock market rebounds, because of the previous experience (seeing that the holdings that made a lot of money have been shrinking, and the stocks will be dumped before turning into negative returns), it will wait until the stock market is very sure to get out of the bear market before entering again.

However, at that time you decide to enter market again, the market index number is usually far from the bottom (because it has rebounded sharply). It is almost certain to get out of the bear market, so the future stock market gains will be relatively low, because the biggest gains in the broader market are from the market bottom to the point that market get out from the bear market. Unless investors stay in the market, most people will miss this period of the biggest gains.

“Everything has to start all over again” means, wait until you’re pretty sure the stock market is out of the bear market, and then you come in, but then you come in again as if you were a novice in the stock market (because you clearing your holdings and stand on the sidelines), all the numbers have to be recalculated, you have no baggage (losses), but there will be no profit or shrinking losses due to the stock market rebound.

You might argue that I at least kept the bullets last time I dumped all the stocks to avoid shrinking funds. That’s true, but you’re still new! At best, you’re just a novice with a little more money than a twenty-year-old investor, mainly because you’ve voluntarily given up on the big rally period I mentioned earlier.

A reminder: the market is up in the long run. The market index when the stock market is out of the bear market will be a lot higher than the index level before the it entered the bear market. There are no exceptions to this, mainly for two reasons:

  • After the stock market rebounded, investors who had left began to flock to the stock market, put money into the stock market and pushed the stock market higher; because everyone thought it was safe to buy stocks now.
  • Another reason is easier to understand, because after a few years of bear markets or crashes, inflation has thinned money, and the rise in the market is just a reflection of inflation, which is nothing to be happy about. The index just went up.

After a few years of bear markets or crashes, the time you can accumulate with the stock market is shortened, isn’t it? Because you left the market in a bear market or crash! This has a huge impact because time compounding stops during this period. This is the biggest impact.

The margin of safety has been raised

But one thing is certain, the deeper the stock market falls, the safer and more profitable it is for long-term investors, and Buffett holds a similar view. Meaning unless you’re going to sell the stock tomorrow, the stock price doesn’t mean much to you, why? Because the deeper the fall, the higher the margin of safety of the stock, and the lower the probability of losing a lot of money in investment, which is easy to understand. That’s why Buffett famously said, “Be fearful when others are greedy, and be greedy when others are fearful.”

No fear if long-term investing

Saying no to fear would be a lie. But I’m a very long-term investor myself, so I don’t really care about short-term negative returns for one to two years, because that’s what all long-term investors have to go through. But I admit it’s easier said than done, and it’s hard to get through. Because most investors vow to be a long-term investor when the stock market makes money or is flat, but once the stock market pulls back or crashes, most of them will sell their holdings to avoid immediate loss.

Where did the holdings in your portfolio come from?

Why do most people rush to get rid of their holdings during a crash or a sharp pullback? One of the major reasons is that most people have no idea of the holding in the portfolio. They bought because they were recommended by relatives, friends, colleagues, and have performed well in the past, celebrities, touted stocks, media, everyone did the same!

If your holdings are bought for any of the above reasons; not because of your own research, knowledge of your holdings, within your circle of competence, or confidence in company outlook. When the market goes down, even if you can’t convince yourself, how can you resist the market downturn or the masses?

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