Friday, January 2, 2015

Market Crashes -- How to Manage Them

The fear of market crashes often causes far more harm to portfolios than the actual magnitude of the crashes. Keeping a perspective on how crashes work and how you mitigate the damage is key to keeping control and managing your own fears. Here are some key steps that help you take a lot of the worry out of crashes.
1. Don't let time control you – You should control time
When crashes occur, the daily headlines can make even the strongest of investors feel like the sky is falling. We shouldn't fault the Press; after all, each day, they have to seek out headlines that look dramatic. However, what is most often missed is what happens over time. Often times, the bigger news is in what occurred in the previous few years as well as what happens over the next few years. After all, your investing profile typically covers decades, so what happens in any given month or year really doesn't matter so long as you don't make any sudden adjustments to your portfolio.
One of the big surprises throughout history is that typically, markets often rise dramatically just a few years prior to a crash. Just look at the most notable of all crashes in the US stock market over the last century.

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Our markets were not unique. For instance, you can see a similar pattern in Japan in the last century that also suffered a major market crash in 1989.

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And these are not isolated crash events. Look back on one of history's most celebrated most crashes – The Great "Tulipmania" crash in 1636.

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What you see in these markets is that so long as you were accumulating over a number of years, your average purchase was often likely be far lower than the peak market price.

2. "Trickle Investing" works!
The above examples show that so long as you keep the discipline of only investing a little into each market each year, but consistently over a period of decades, your average purchase price over the longer period will be substantially lower than where the crash takes the market price level. And when you factor in dividends, you will often still be ahead.

3. To mitigate any losses due to booms and busts, "Trickling Out" is just as important as "Trickling In.
Take another look at the worst market crash of the last century. Say you retired at the worst possible time in 1930. So long as you kept the discipline and only sold what you needed to live off of each year, despite the terrible 1929 /30 crash, you still were able to make much more money over time than if you had just left the money in the bank. And in fact, as you can see in this example, you could even keep your money growing despite your measured withdrawals to live off of in your retirement years.

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Your money in this example never runs out if you invested in a broad mix of equities including their dividends.

"You don't lose on what you don't sell."

In other words, the only money you would have lost during the down markets is just on the small amount you sold that year for your living expenses. This allows the bulk of your money to keep growing, albeit with constant fluctuation. In this way, you get paid back in increased return for stomaching the inevitable volatility.

4. Diversifying really takes the sting out of market crashes
By mixing asset classes, you can mitigate the ups and downs considerably. This becomes especially important after you retire. Note in the below chart that mixing in fixed income with equities at a rate of 40% fixed income to 60% equities and continuing to follow the Trickle Investing rule, means your volatility is limited throughout the years.

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With such a mix, rather than running out of money prematurely, you can live a long time and still leave money for your family.

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