Avoiding panic when it is raining stock brokers ain’t easy
On what was later to be called Black Monday, in 1987, at the end of a very busy day I called my broker. Remember now, this was when we had brokers and before cell phones, personal computers, the internet and on-line trading.
“Hi Bob,” I said cheerfully. “How’s it going.”
There was a long silent pause. “You’re kidding,” he said. “Right?” He sounded dreadful.
“Kidding about what?”
“Jim, we’ve just had the biggest meltdown in history. Customers have been screaming in panic at me all day. The market is down over 500 points. Over 25%.”
That was the point at which I joined the rest of the planet in being absolutely stunned. It is hard to describe just what this was like. Not even the Great Depression had seen a day like this one. Nor have we since. Truly, it looked like the end of the financial world.
Time Magazine, 1987
As any educated investor does, I knew that the market was volatile. I knew that on its relentless march upwards there could and would be sharp drops and bear markets. I knew that the best course was to hold firm and not panic. But this. This was a whole ‘nother frame of reference.
I held tight for three or four months. Stocks continued to drift ever lower. Finally, I lost my nerve and sold.
I just wasn’t tough enough. That day, if not the absolute bottom, was close enough to it as not to matter. Then, of course and as always, the market began again its relentless climb. The market always goes up.
It took a year or so for me to regain my nerve and get back in. By then it had passed its pre-Black Monday high. I had managed to lock in my losses and pay a premium for a seat back at the table. It was expensive. It was stupid. It was an embarrassing failure of nerve. I just wasn’t tough enough.
But I am now. My mistake of ’87 taught me exactly how to weather all the future storms that came rolling in, including the Class 5 financial hurricane of 2008. It taught me to be tough and ultimately it made me far more money than the education cost.
Here’s the thing you need to understand:
The market always goes up.
Always. Bet no one’s told you that before. But it’s true. Understand this is not to say it is a smooth ride. It’s not. It is most often a wild and rocky road. It’s not easy. Reader JTH in the comments for Part I says:
“We’ve stayed the course, with a side-dish of panic.”
Great line there JTH, and staying the course is always served with a side dish of panic. That’s why ya gotta be tough.
Because the market always, and I mean always, goes up. Not each year. Not each month. Not each week and certainly not each day. But relentlessly up. Take a moment and look at this:
The Dow Jones Industrial Average 1900 – 2012
Can you find my ’87 blip? It’s there and easy to spot, but not quite so scary in context. Take a moment and let this sink in. You should notice three things:
1. Trend is relentlessly, thru disaster after disaster, up.
2. It’s a wild ride along the way.
3. There is a Big, Ugly Event.
Let’s talk about the good news first. We’ll tackle points 2 & 3 next time.
To understand why the market always goes up we need to look a bit more closely at what the Market actually is.
The chart above represents the DJIA (Dow Jones Industrial Average). We are looking at the DJIA because it is the only group of stocks created as a proxy for the entire stock market going back this far. Way back in 1896 a guy named Charles Dow selected 12 stocks from leading American industries to create his Index. Today the DJIA is comprised of 30 large American companies.
But now let’s shift away from the DJIA Index, which I only introduced for its long historical perspective, to a more useful and comprehensive Index: MSCI US Broad Market
If you click on that link it will take you to a article announcing that Vanguard is using this Index in crafting the Vanguard Total Stock Market Fund (VTSAX). (Update: As of June 3, 2013 VTSAX is now using the CRSP US Total Market Index)
The Index and VTSAX are exactly what they sound like: Groupings of every publicly traded US based company. By design they are almost precisely the same. Since we can invest in VTSAX, going forward I’ll be using it as our proxy for the Stock Market overall.
In 1976, when John Bogle invented the Index Fund he gave the world a wonderful way to invest in the entire US Stock Market. This is the single best tool we have for taking advantage of the market’s relentless climb up. VTSAX is the market and as such does the exactly the same.
OK, so now we know what the stock market actually is and we can see from the chart that it always goes up. Let’s take a moment to consider, how can this be? Two basic reasons:
1. The Market is self cleansing.
Take a look at the 30 DJIA stocks. Care to guess how many of the original 12 are still in it? Just one. General Electric. In fact, most of these companies didn’t exist when Mr. Dow crafted his list. Most of the originals have come and gone or morphed into something new. This is a key point: The market is not stagnant. Companies routinely fade away and are replaced with new blood.
The same is true of VTSAX. It holds virtually every publicly traded stock in the US market. A little over 3600 at last count. Now, picture all 3600 of these companies along a classic bell curve graph.
Generic Bell Curve Graph
Those few at the left will be the worst performing. Those few to the right, the best. All those between at various points of performance.
Ok, looking to the left what is the worst possible performance a bad stock can deliver? It can lose 100% of its value. Then, of course, it disappears never to be heard from again. As new companies grow, prosper and go public they replace the dead and dying. The Market (and VTSAX as proxy) is self cleansing.
Now let’s look at our top performers on the right. What is the best performance they can deliver? 100%? Certainly that’s possible. But so is 200, 300, 1000, 10000% or more. There is no upside limit. As some stars fade, new ones are on the rise.
The net result is a powerful upward bias.
But note, this only works with index funds. Once “professional management” starts trying to beat the system, all bets are off. They can, and most often do, make things much worse and they always charge more fees to do it. We’ll talk a bit more about this in a later post.
2. Owning stocks is owning a part of living, breathing, dynamic companies, each striving to succeed.
To appreciate why the Stock Market relentlessly rises requires an understanding of what we actually own with VTSAX. We own, quite literally, a piece of every publicly traded company in the USA.
Stocks are not just little slips of traded paper. When you own stock you own a piece of a business. These are companies filled with people working relentlessly to expand and serve their customer base. They are competing in an unforgiving environment that rewards those who can make it happen and discards those who can’t. It is this intense dynamic that make stocks and the companies they represent the most powerful and successful investment class in history.
So, now we have this wonderful wealth building tool that relentlessly marches upward but, — and this is a major but that causes many if not most people to actually lose money in the market — boy howdy it’s a wild and unsettling ride. Plus, there’s that Big, Ugly Event. We’ll talk about those next.
Disclaimer: Like everything on this blog, this is only sharing ideas. You are solely responsible for your own choices.