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How To React To A Market Crash

By William Baldwin

The scaremongers are out again. I’m very fretful about the damage they could do to your net worth.

Since anxiety is built into our amygdalas, we can’t displace it entirely. But we can learn to redirect it. Let’s look at three investor fears propagated by various doomsayers and see how to divert those fears into useful behavior.

The high-frequency hype. Michael Lewis made a bestseller out of the theory that rapid-fire traders using well-placed computers are sucking the life out of the stock market, leaving nothing for the little guy.

Well, if you trade in and out of your Tesla 300 times a day, you’re at a disadvantage. But normal people shouldn’t give the high-frequency crowd a second of thought.

If you want to worry about trading, think about problems that are entirely of your own making. When you move in and out of a thinly traded stock or when a big fund you own moves in and out of a stock, even one with decent volume the price gets pushed away. Turning over a portfolio once a year can easily clip half a percentage point off returns.

Solution: Don’t trade. Buy and hold. Sell that fund with the overactive portfolio manager and replace it with an index fund.

The Ponzi panic. Writing in these pages a few months ago, the economist Laurence Kotlikoff declared that the Securities Investor Protection Corp. is a scam and that you should close your brokerage account immediately. What got him so worked up? Bernie Madoff was a broker, he stole money and the SIPC didn’t make the victims whole.

Really, is there a risk that Charles Schwab will abscond to Brazil with your assets? It’s about equal to the risk that you will be killed by a meteorite.

To protect yourself from crooks, have your assets custodied at a trillion-dollar firm (Schwab & Co. qualifies), and if you engage a money manager, grant power to trade but not to move money out.

Now let’s redirect your worrying from something with a one-in-a-billion probability to something with a 50-50 probability: the risk that a money manager will charge you 1% a year in a futile effort to beat the market. Keep that up for 30 years and you’ll be 26% poorer.

Solution: Fire the manager. Get an index fund. Schwab has some good ones: Broad Market (SCHB), U.S. Aggregate Bond (SCHZ), U.S. Small Cap (SCHA) and U.S. TIPS(SCHP).

The volatility vapors. The Fed twitches, stocks take a spill, and the market strategists go into a fainting spell.

What a waste. It doesn’t matter a whit whether stock market fluctuations average 1% a day or 2% a day. Even that 20% one-day blip 27 years ago didn’t have any lasting impact on your prosperity, at least if you managed to sleep through it. The market popped back.

If you want to worry about stock market fluctuations, forget the one-day volatility and think about multidecade volatility. There’s a lot of uncertainty about what’s going to happen to your investments between now and when you spend the money in retirement, and it is not in any way captured by vol statistics that market experts talk about.

Expected stock market volatility (annualized) implied by the prices of options on CBOE over the past year. (Source: YCharts)

Consider this possibility: The past 32 years have been deceivingly good. Stocks did well as globalization and computerization rewarded owners of capital. Bonds did well as inflation was tamed.

The next 32 years could be very different: Earnings growth slows, price/earnings ratios shrink, inflation picks up. A blend of stocks and bonds that earned a 5% real annual return from 1982-2014 might deliver only 3% from 2014-46. The two-point difference has a large impact, almost 2-to-1, on what a dollar put aside at age 40 will buy you when you’re 72.

You’re not going to like my cure for this source of mental anguish. You should save more. Putting away 10% of your paycheck is not adequate. Double that.

Source: forbes.com