I’ve been shouting about the virtues of investing in stock index funds for years now.  In just the last year’s worth of posts, I’ve made many confident¹ assertions about the merits of stock funds including:

• The “best” asset allocation is 90% stocks if you plan to invest for five years and 100% stocks for longer timeframes.
• The routine annual volatility of stocks is essentially irrelevant to long-term asset allocation decisions.
• Stocks go up most of the time almost regardless of the investing timeframe or country².
• Stocks are the top-ranked asset in terms of annual returns over the last 50 to 100 years.
• A 100% stock portfolio is probably the best way for retirees to avoid sequence-of-return risk.
• On average, forecasts for the next decade project that nominal annualized returns for stocks will be 4% higher than for government bonds.

And over the years, I’ve just as confidently pointed out the relative inferiority of other established assets classes including:

• Bonds – The current low yields on intermediate and aggregate bond funds mean the likely outcome for most bond investors is an inflation-adjusted loss over the long term.
• Gold – Over the last 50 years, gold has been more volatile than stocks while producing lower returns than bonds and even cash.
• Real Estate – Rental real estate (being a landlord) has the potential to generate stock-like returns, but it comes with big uncertainties, geographic limitations, random hassles, and a lot of hard work.

Stocks seem like the best game in town.

A House of Cards

However, many observers have pointed out that the stock market is currently seething with a bullish sentiment.  Feelings are so (dare I say it) exuberant that a big crash seems almost certain to ambush euphoric stock investors soon.  There are more than a few warning signs:

• Worries about a stock market bubble are rampant, which paradoxically, is consistent with the psychology of past bubbles.
• Stock market valuations are at all-time highs, except for a brief period around 2000.
• Investors are holding more stocks than ever, which has often presaged poor stock returns.
• Zero-interest-rate policies and stimulus checks have likely flooded the stock market with money.
• Free trades and game-like trading apps have attracted herds of uninformed newbies to stock market gambling.

And if stocks aren’t expensive enough for you, the accompanying cryptocurrency craze seems completely unhinged.  One Bitcoin now trades for more than $55,000 based mostly on the hope that it will someday become incredibly useful.  The value of Dogecoin, which was literally started as a joke, has increased by over 4000% year-to-date.  And one enterprising guy recently created a cryptocurrency called “Scamcoin”, which he transparently presented as nothing more than a prank.  He made about $2000 in an hour.

I lived through the Dotcom bubble, and this all feels like déjà vu, although the specifics are different.

Lambs to the Slaughter

For more than a decade, the stock market has climbed relentlessly with only a few relatively minor slumps along the way.  (Yes, I consider March 2020 a “minor slump” for reasons I’ll explain in a moment.)  That means that many of today’s stock investors have never experienced a really scary crash or prolonged bear market; they’ve just seen stocks go consistently up.

And here I sit blithely singing the praises of stocks.  I imagine that my blog posts only reinforce younger readers’ existing biases towards stocks, grown from shallow yet compelling personal experiences.  Observing the Dotcom bubble, Warren Buffett said, “Nothing sedates rationality like large doses of effortless money.”  Since 2008, the S&P 500 is up 525% or 14.8% annualized!  Effortless money indeed.

So, what happens when young investors read my posts, load up on even more stocks, and then the stock market crashes, as it eventually will?  I’ve written that “worrying” about the future is a very unmindful thought process.  But if I worry about anything, at the top of my list is luring naive investors into the turbulent waters of stock investing.

Understanding Versus Feeling

Sure, most young investors are aware that stocks have periodically endured crashes and long bear markets.  But that’s entirely different from the experience of investing during the Great Financial Crisis, Dotcom bubble, Stagflation, or the Great Depression.  Most younger investors have heard tales of these events, but they probably seem like the quaint reminiscences of now senile grandparents.

For example, when I wrote about the dangers of using leveraged funds in a risk parity strategy, the most common criticism (mostly from people who seemed younger than me) was that the Fed would never allow runaway inflation like the 1970s to occur again.  While that particular fact may be true, it completely fails to consider future events that may have a similar effect but due to different causes.

On top of that, cognitive research shows that our assessments of our own emotions are often capricious.  In one experiment, test subjects were asked to fill out a “life-happiness questionnaire”.  But before filling out the questionnaire, half the test subjects “luckily” found a dime, which had been planted by the researchers.  And of course, the folks who found the dime reported significantly happier lives than those who found no dime.  You can read about many other ways that we misjudge our feelings in Daniel Kahneman’s book, Thinking Fast and Slow.

If assessing your current feelings is tough, think how much more difficult it is to predict exactly how fearful and miserable you will be if your stock portfolio drops by 35% in value tomorrow.  Or what if it grinds down slowly by 50% over several years?  And if you can’t predict how you will feel, you can’t really predict whether you might sell in a panic or do something else unproductive.  This is one reason why simple “risk tolerance” quizzes that try to predict our emotions when faced with unknown future events seem like a joke to me.

Even for folks who’ve lived through past crashes, cognitive research suggests they may still find it difficult to predict their feelings during the next crash.  After all, the amount of money at stake, time to retirement, market conditions, and economic circumstances will always be at least a little different.

So, for inexperienced investors, I submit that the leap of mental processing required to predict their feelings in the next stock market crash is like trying to jump the Caesar’s Palace fountain on a motor scooter.  Perhaps a few will make the cognitive leap but most will fall disastrously short.

Use Your Imagination

Some of you are probably thinking, “Well, I made it through the pandemic crash of March 2020”.  But the March 2020 slump was pretty mild in my opinion.  Here’s a graph of the S&P 500 for 2020 in percent gain/loss to refresh your memory.

The key timeframes for investors who endured this slump were:

• Duration of the slump (from prior peak to the bottom): 1.5 months
• Duration of recovery (from prior peak to regaining the prior peak): 6 months.

Now let’s compare that to the crash associated with the Great Financial Crisis in 2008.

• Duration of the crash: 1.5 years
• Duration of recovery: 5.5 years.

The duration of the crash and recovery from the Great Financial Crisis was over an order of magnitude longer than the pandemic slump last year.

And here’s the Dotcom bubble bursting and subsequent recovery.

• Duration of the crash: 2 years
• Duration of recovery: 6.7 years.

Imagine watching your portfolio value decline, recover a little, and then decline some more month after month for two whole years.  I don’t have to imagine because I lived it.  And I recall that by the second year, I felt kind of crazy whenever I even thought about my stocks.  (This was back before I practiced daily mindful meditation.)

And if you think that sounds bad, consider this.  It turned out that the recovery from the Dotcom crash was just a temporary peak right before the Great Financial Crisis.  So, in actual fact, the two events are better viewed in sequence, which is how they were experienced by poor sods like me.

• Duration of the crash: 8.5 years!
• Duration of recovery: 12.5 years!

This is why they call 2000 to 2010 the “Lost Decade”.  I remember having a feeling in 2007 that I’d finally dug out from the Dotcom bubble.  I was just beginning to believe again that stocks could make me money.  And then the market crashed to a new 7-year low!  It’s no wonder I turned to mindfulness to help with stock investing.

I should note that these are all price change graphs.  With dividends reinvested and new money invested periodically along the way, the durations of losing and recovering money would be shorter.  But in my experience, it’s hard to ignore those brokerage gain/loss price statements showing capital losses years after the initial investment.

My Warning

You may love that stocks have performed great for you over the past few years.  You may love all the facts supporting a 100% stock fund portfolio for long-term investors.  Further, you may academically understand that stocks periodically crash or go sideways for years.  You may believe that you have the moxie (or guts or cajones, or whatever you like to call it) to withstand those crashes and stick to your plan of buying and holding stocks for the long term.

But here’s my warning.  If you’ve never experienced a crash before, you have no idea what it’s actually going to feel like.  And so, there’s a fair chance you’ll panic and start selling stuff at a loss.  Last year’s pandemic slump was a walk in the park because you only had to stomach it for a few months.  The next crash will be for who knows how long.  Maybe your digestive system will tolerate a year of the markets slowly grinding sideways.  But your butthole’s really going to pucker if there’s a second major leg down adding another year to an already prolonged bear market.  And then you still have to stay calm throughout a potentially long and tedious recovery.

Conclusions

Right now, everyone’s advice seems to be some version of, “Take some stock bets off the table.”  But what then?  Cashing in your chips and going home is absurd when you consider that the nominal annual returns on cash are currently a mere half a percent at best.

Mindfully investing is dedicated to the idea that we can manage our emotional reactions and stick to our long-term investing plans, even if they feel risky.  I still firmly believe that.  Therefore, I still also firmly believe that a moderately diversified set of low-cost index funds is the best plan for mindful investors at market peaks, market bottoms, and everywhere in between.  The key is to hold those stocks through thick and thin.

Through a combination of experience and mindful meditation, I’m 99% sure that I won’t change my allocations one bit before, during, or after the next crash.  But I can’t say the same about everyone else.

If your not as sure as I am, then you should step back and consider whether you may react poorly to the next crash.  While it’s indeed difficult to predict how you will feel and react in the future, no one is in a better position to assess your emotions than yourself.  I think a good starting point would be to consider how you felt and how close you came to doing something unproductive in March/April of 2020, assuming you were investing then.

If you feel like your resolve could waver in the next crash, I suggest you seriously think about taking some stock bets off the table.  Such a decision is clearly a form of market timing, which is unmindful in multiple respects.  But in another sense, it’s a decision that simply pre-empts future market timing decisions that are spurred by emotional duress, which are usually the most hazardous to your wealth.

And what if you were one of those people who couldn’t stand the heat back in March 2020 and sold or even fiddled with some of your long-term allocations?  For you, I’d say that you have absolutely no business holding 100% in stock funds or anything approaching that.  The pandemic slump was a warning that you’re going to fold like a house of cards when the next real bear market shows up.

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1 – I’m confident about my assertions because I always try to back them up with solid data sources and rational analysis.  However, we all know how statistics can be used to support the worst kinds of lies, and we can all make mistakes.  So, my confidence is no guarantee of anything.

2 – There are some caveats here.  I’m talking about reasonable investing timeframes of a year or more, not day trading.  Further, I’ve confined my assertions to the stocks of developed market countries.  And a handful of those countries have admittedly only gone up about 55% to 65% of the time over the last 50 years, as measured by a 10-year investing timeframe.