Most investors cringe at the thought that recent market volatility could be a prelude to a crash. But if you're investing money you don't plan to draw on for many years, a good old-fashioned market meltdown that scares the bejeezus out of investors could be a blessing in disguise.
It may sound counter-intuitive. But a market collapse could actually work to your advantage by helping you build a larger nest egg. That's because the rate of return you earn on your savings can be a lot higher for the dollars you sock away in the wake of a market downturn than for the money you invest when stock prices are at or near a peak and poised for a major decline.
Here's an example.
Let's say you invested $10,000 in the Standard & Poor's 500 index back in March 2000 when stock prices were at their dot-com highs and just before the tech bust drove the S&P 500 down by almost 50% over the next two and a half years. And let's further assume that you not only kept your money in stocks throughout that stomach-wrenching downturn, but re-invested all dividends along the way. Today, 15 and a half years later, your original ten grand would be worth just under $17,500, which translates to an annualized return of roughly 3.6%.
By contrast, $10,000 invested in the S&P 500 at the market's post-dot-com trough in early October 2002—after the index had fallen by roughly 50%—would be worth just over $32,000 today. That $22,000 gain over a period of about 13 years translates to an annualized return of roughly 9.4%, or more than double the 3.6% annualized gain an investor earned by investing when stock prices had peaked in 2000 and were on the verge of a major meltdown.
But not all investors benefit equally from the higher rates of return that follow a crash. A young investor just starting to save for retirement has the most to gain. After all, the younger you are, the less likely you are to have lots of money already invested that will take a big hit in a major setback. So the bulk of your investment stash will be in the form of new savings that will miss the downturn and earn the higher returns that come with a market rebound.
If you're in mid-career and have been saving and investing for many years, a market crash is more of a mixed blessing. True, you'll be able to take advantage of a post-crash surge with the new money you pour into retirement accounts. But the money you've already accumulated in your 401(k) and other accounts could take a serious hit in the downturn.
Retirees and people on the verge of retirement typically have the least to gain from a market collapse, since they're most likely to have built sizable account balances whose values could drop steeply during a meltdown yet aren't likely to be investing enough new dollars to take much advantage of the subsequent recovery. A major market setback can be especially troublesome if you're drawing on your investments for retirement. The reason: the combination of market losses and withdrawals, especially early in retirement, can so deplete the value of your nest egg that you won't have enough capital left to undo the damage even if the market sharply rebounds—which in turn can increase your chance of running out of money before you run out of time.
But even though it's true that savings invested after a market crash can grow a lot more quickly than money invested at a market peak, it's not as if you can make that fact the cornerstone of your retirement investing strategy. For one thing, as a practical matter you can't choose to invest only after the market has bottomed out after a severe downturn. It's easy to look back with 20/20 hindsight to see when share prices hit a peak and when stocks started to rebound after a meltdown. In real time, however, you can never really know whether prices have peaked or troughed. So you can't cherry pick the most advantageous times to invest.
And even if you were somehow able to divine when stock prices will fall and then turn around, big market meltdowns don't come along all that often. Which means the time spent with your money on the sidelines in cash or whatever while waiting to capitalize on outsized post-crash gains would significantly drag down your overall long-term returns, making it difficult to build an adequate nest egg or make it last in retirement.
The basic reality of investing is that as the market fluctuates over time, some of your savings dollars will earn a lower rate of return (i.e., funds invested when stock prices are inflated), others will see higher gains (the money invested after a crash) and still others will earn a return somewhere in between (savings invested when stock prices are neither at a peak or trough). Given that reality plus the fact that it's virtually impossible to predict the market's ups and downs—the best investing strategy is to settle on a mix of stocks and bonds that jibes with your investing goals and risk tolerance and, aside from occasional rebalancing, stick with it.
Indeed, sticking with the mix of stocks and bonds you've determined is appropriate is especially important during periods of upheaval when investors feel most anxious and are most inclined to jettison stocks. After all, if you abandon your strategy and avoid stocks when it's scariest to invest in them, you may very well miss out on the spectacular gains that typically follow a major market setback—and end up with a much smaller nest egg at retirement or go through it more quickly than you expect.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org. You can tweet Walter at @RealDealRetire.
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