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As human beings we’re not very good at managing or understanding risk, this is because our primal instinct is fight or flight. We want to either hit it or flee from it, but our response to risk needs to be much more nuanced.
One example of the way we manage risk badly is that many of us buy the stock market at the top and sell it at the bottom for the simple reason that it feels right. Buying at highs seems right because things are going up and everybody is excited, while selling at the bottom seems right because things are collapsing and people are gloomy. Yet we know that the inverse is the right course of action – buy at the lows when everybody else is fearful.
Our mismanagement of risk was further driven home for me last week when I had a meeting with a 28-year-old who revealed that her entire investment portfolio (and a chunky one of around R100 000) is invested in money-market funds. When I asked her why, she said the stock market was dangerous and friends of hers had lost money. Both statements are correct, but she missed the main point of investing: time.
At 28 years old, she has almost 40 years until retirement and in that time the stock market will crash at least four times, maybe more. But even with those four crashes her investment will show significant growth, beating inflation and other asset class returns, resulting in real wealth creation.
We’re overly fearful of market crashes and/or corrections. Yet they’re fairly common. Data from the S&P 500 shows that a 10% correction happens on average every year, a 20% correction every three to five years while a 30% to 40% correction (crash?) happens about once a decade. The monster 50% correction has only happened twice in the last 100 years.
So not only are they fairly common, but the market still offers inflation beating returns over time in spite of these market corrections.
I still clearly remember my first share purchase on the JSE, it was October of my matric year and I bought a few hundred rand of DiData.
The problem was that the year was 1987 and a week later we had a real market crash as the Dow Jones shed over 22% in one day, now called Black Monday.
At the time it freaked me out, but my grandfather, who’d been teaching me about stock markets, laughed, pointing out this was going to be the first of many crashes I would experience and I should get used to it.
He was right.
I have since witnessed the 1998 crisis, the dot-com bust and most recently the 2008/09 global financial crisis. That makes four in just under 30 years.
More importantly, if instead of DiData I had bought the index – we didn’t have exchange-traded funds (ETFs) back then and the index would have been the All Share – I would have paid under 2 000 points and today it is almost 50 000. This massive wealth creation excludes dividends that would have significantly increased my returns.
So, sure, markets are dangerous, but in reality that only applies to the short term – over the long term they are the best way to create wealth. If we have time on our side, we should use that time by investing in the market (invest simply using ETFs) and create real wealth for ourselves. The short-term moves will be noisy and scary, but ignore them, focusing instead on the long-term wealth creation aspect of the market.
This article originally appeared in the 17 September 2015 edition of Finweek. Buy and download the magazine here.
