Why would a market correction or crash be great for me?

2018-02-10 - Market crash is good for me

Since last week, we saw the S&P 500 drop by 7.5% from top to bottom. This caused a lot of panics from what I saw in the news. Weirdly, I am in the few that was pleasantly surprised. Let me explain why.

Part of my investing strategy relies on two golden rules that do all the magic:

Rule 1:  Always invest for the long-term

This is one of the fundamentals of investing. When I say long-term, I mean 20-30 years from now. Simply by knowing that, I expect the market to correct itself or crash a couple of times during my life. I never know when it could happen, and we have no control over that. That is why you got to prepare intelligently by diversifying to avoid losing it all. I know it is easy to start panicking when you see your hard-earned money invested and going down, but remember, you won’t lose anything if you don’t sell. Simply keep it cool, ride the market wave and relax, you will thank yourself for not having sold everything at the bottom when it bounced back as it did for every single major crash in our history. I know this doesn’t explain why the correction from last week is great for me. Let me show you the rule number 2 and you will understand.

Rule 2: Pay yourself first

This is the core of my investing strategy. It involves a lot of discipline to apply properly, but it will be all worth it later. Paying yourself first is basically to commit yourself to invest the same percentage of your income at the same interval of time. That percentage is taken from your income before anything else, even taxes. Just think of it as a tax you force yourself to pay for the future, and you pay it to no-one else than you. Remember that it is a percentage of your income. This means, if your income goes up, you put up more towards investing. By doing this over a long period of time, I will benefit from the magic of compounding (the secret sauce of investing). It is also important to note that you should decide the percentage as it would be money you could afford to live without for a long time. Don’t invest money you need to live.

Conclusion

In my case, I am doing this every month as part of my strategy. No matter the state of the market. By using this strategy over the long-term, whenever the market goes down, I can buy more assets at a cheaper price every month that I invest. The sooner it crashes, the more the compounding will pay because the re-invested interests/dividends will be able to buy more assets.

No matter where the market is going, it’s a win-win scenario for my strategy. If it goes down, it means I can buy for cheap, if it goes up, I can rebalance my portfolio to secure the gains that the market offers me before the next correction or crash, or as I call it, the wall street Black Friday.

If you want to know more about how rebalancing works, check out my other post, I’ve explained how the mechanics work:

Ray Dalio’s All-Weather portfolio’s secret

 

Stay cool, relax and enjoy!

Ray Dalio’s All-Weather portfolio’s secret

If you have read Tonny Robbins’ book, MONEY Master the Game, you probably have learned one of the core principles of building wealth, which is to NOT lose money. Most people tend to forget about that rule by chasing high returns instead, which can be disastrous if a market crash would occur without preparation.

In his book, Tony dedicates a whole chapter explaining Ray Dalio’s strategy to do apply this core rule by teaching us about the All-Weather Portfolio. This brilliant portfolio prefers protecting us from losing money by using specific risk allocation per asset type.

Having the exact asset allocation given by Ray is great, but there is a secret key element that you must use: Portfolio rebalancing.

 

I’ve decided to dig in the mechanic using real numbers that happened in the worst market crash in history: The 2008-2009 market crash, where the S&P 500 crashed by ~53% from peek to bottom. We are talking worst case scenario here.

I’ve created a spreadsheet with an investment of $100,000 before the crash. By looking at historical data, I have extracted the peak, bottom and recovery date of the S&P 500 to test out the rebalancing mechanic. I got to say, it is impressive.

  • Peak date, where the stock price was at it’s top: October 12, 2007
  • Bottom date, where the stock price was at it’s lowest: February 27, 2009
  • Recovery date, where the stock price got back to the previous peak before crash: March 28, 2013

In this scenario, I’ve applied a portfolio rebalance at the optimal moments, so at the bottom of the crash, then after recovery, which won’t happen exactly like that in real life, since during a crash, we can’t know when we hit the bottom exactly. The more often we rebalance, the better. In the book, Tonny recommends at least once a year.

Important to note here, I’ve used some ultra low-cost vanguard index funds to match the asset allocation suggestions in the book. You can change these funds with any other funds you prefer, as long as they are stocks, long term bonds, intermediate bonds, commodities/gold.

I did this to keep the logic simple for better understanding of the mechanic.

Here are the steps results:

1 – Here we have the initial $100,000 investment using the suggested asset allocation.
2 – After the crash, our portfolio dropped from $100,000 to $74,787.82. All assets have been affected differently. This is where most people do the worst possible error. They get scared and sell stocks to try to keep the remaining. Since stocks are more volatile than bonds, our stock portion is now only 19% of our portfolio. For a smart investor, this is where the magic happens, we need to rebalance the portfolio.
3 – We sold a big chunk of our bonds to buy back stocks and commodities at a discount price, so we get back to our recommended allocations.
4 – The storm is over, the market has recovered, as it always did historically after a crash. Our stock portion is now worth too much! We got to rebalance again to get ready for the next financial winter.
5 – After our final rebalance, here are the numbers. Our portfolio is up and ready for the next storm to come. In this scenario, we started with a $100,000 investment, without putting any new money in there, we went up to $124,463.65, a 19.66% gain, where as most average investor lost almost everything because they either sold the wrong asset at the wrong time or they were too stock heavy and had no liquidity ready for a quick discount swap.

Conclusion

Rebalancing is the key here. Keep in mind, we did not put any new money in the portfolio during that time, just imagine if you kept using the discipline to keep investing every month, with the stock discount, the portfolio could be worth double or even triple that in some cases. Also, one more thing, THIS USE CASE DOES NOT EVEN INCLUDE DIVIDENDS, which you can take as a bonus!

 

I hope this crash cycle study helped you or someone you know to avoid the painful feeling of getting caught unprepared when a crash comes.

Just remember the golden rules I learned from Warren Buffet:

Rule #1: Don’t lose money

Rule #2: Don’t forget Rule #1

 

Here is the Excel file if you want to play around with it.

Crash cycle rebalancing

Enjoy.