We can quickly lose substantial amounts of our money when the stock market crashes.
For example, during the Great Financial Crisis (GFC) in 2008 and 2009, the Straits Times Index (SGX: ^STI), Singapore’s stock market benchmark, plummeted by more than 50%. By incurring a 50% loss on a stock, we would need a gain of 100% just to break-even. Even if we were to lose “just” 25%, we still require the stock to gain 33% to recover our loss.
Of late, the Straits Times Index has been falling. As of yesterday, the 30-stock index has declined by around 15% from its peak in May this year.
Amid current volatile times, it seems to make sense to sell all our shares and buy them later when the stock market is cheery. By cutting our losses earlier, we have the opportunity re-invest at a lower price later – it also feels better for our psyche. But, it would actually be better for you if you did not undertake the endeavour. Here’s why.
It’s not that easy
Logically, it sounds simple to cut our losses, sit on cash, and wait for things to become better.
The problem is, we can never know when the recovery will happen. If you remember the first few years after the GFC, many were talking about the “green shoots” of recovery and were questioning if the stock market gains after March 2009 were sustainable. In fact today, many are still in denial that the stock market has pulled through from the depths of the financial crisis. Missing out on those gains could have cost investors in the form of opportunity risk.
Many studies have also shown that market timing doesn’t work.
For example, one study by Index Fund Advisors showed that for a 20-year period from 1994 to 2013, the S&P 500 index had generated an annual return of 9.2%. A $10,000 initial investment would be worth $58,000 at the end of 2013. However, if an investor had missed out on just the 10 best days out of those 20 years, the annual return would have fallen to just 5.5%, meaning the ending amount from the same initial investment would be just $29,000.
The pioneer of index funds, John Bogle, once commented:
“Sure, it’d be great to get out of stocks at the high and jump back in at the low… [but] in 55 years in the business, I not only have never met anybody who knew how to do it, I’ve never met anybody who had met anybody who knew how to do it.”
Therefore, it doesn’t pay to time the market; time in the market is more important.
Instead of cutting losses, what we should do first is to ensure we have invested in strong businesses which are cash-rich. Since such companies usually pay a dividend, we can collect their dividends while waiting for the stock market to recover. With our dividends and falling share prices, we can then buy more shares of our companies cheaply.
However, if we had invested in duds in the first place, then culling them would make sense, as the share prices of poor companies may never recover after a stock market crash.
Worried about the overall state of the market? Do you know the 1 thing you should never do in the stock market? The Motley Fool Singapore’s new e-book lays out a plan to handle market crashes, details the greatest advantage you have as an investor, and looks at decades worth of market data to bring you the smartest insights on investing. You can download the full e-book FREE of charge—Simply click here now to claim your copy
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.