Whenever I do a video related to stock market crashes, views explode. This means investors worry about crashes and recessions. I think I can help with that.
The best thing if and when a stock market crash, economic collapse or recession come, is to have a strong plan. In this article I’ll share my plan and perhaps you will find good tips for your investment strategy so that you can increase your long term returns and lower your risks.
I’ve been investing since 2002 when I took advantage of the post dot-com period and I also took advantage of the 2008 financial crisis. That experience is embodied in my plan but things are not that easy.
By the end of this article you should know enough to maximize your long-term investment returns by actually taking advantage of stock market crashes. It is extremely important to know ahead what might happen in order to act decisively when others sell in panic.
I have two portfolios that I manage that make things official as things are done publicly. On my Stock market research platform, I have a 100k lump sum portfolio launched in January 2019 and a model portfolio started with 10k plus 1k added every month launched in May 2018 when I also launched my research platform. I’ll discuss the strategies for each portfolio as those differ because one is a lump sum portfolio, thus no money will be added while the other is a portfolio with constant additions that makes risk management easier.
With 100k as a start and no additional investments, the key is to always manage your risks and have enough cash to take advantage of the opportunities arising when a stock or the whole market crashes.
I am comfortable with a max of 8 positions because it is enough to eliminate individual catastrophic risk but it still leads to long term return maximization.
However, on the cash position, I am currently 75% invested with 7 positions and 25% is in cash.
The cash is 30% of the initial invested amount of 100k where the portfolio is now already at 111k but that I attribute mostly to short term volatility as the portfolio was launched just 5 months ago.
Long-term I will be comfortable with a 20% cash balance with this portfolio. However, stocks are so volatile, especially individual stocks, that my cash balance will also be volatile. The most important thing is that you need to have a strategy when it comes to crashes and my strategy is the following:
The point of this all is not that I’ll do something because stocks crash, there is a risk of a recession or something. The point is that I’ll simply buy things when I can get value on the cheap, when the average cycle adjusted business return is high. The cheaper you can get value and returns, the better protected you are in case of a crash.
Plus, having a clear plan makes you unemotional when it comes to stock price movements, a crucial factor when it comes to investing.
Let me show you the business value I own because I think it will be extremely educational.
I own a lot of the energy, mining, food sector because it is something I can understand well and I feel it is something that will do well over the next decade. Plus, it is cheap at the moment as you can see from the 3rd column the average PE ratios around 10.
If you look at dividends, price to book ratios and debt to equity, you will see that there is no fixed level as I mostly invest in the long-term business outlooks and those things are not reflected into fundamentals yet.
Price to book values are all over the place but that depends what you are buying and whether the value is tangible or future oriented in the form of future cash flows. However, I believe all of the businesses I own currently trade below intrinsic value. This gives me a margin of safety.
I have three things that I believe make investing easy, no matter the economy or stock market:
As said, I believe all of my positions offer a margin of safety in a form or another. This means that if those stocks fall, I’ll be happy to buy more. A real investor is happy when stocks decline because he can simply buy more of the things he owns.
All my businesses have high cash flows or strong balance sheets which means it is unlikely those will ever go bust that gives me another margin of safety.
As said earlier, what makes investing easy is to focus on the business yield and not on the stock price. I try to find businesses that offer long term returns of 15% and above. This involves a lot of work to find such investments, understand them across the cycle and then buy when the risk is low and reward high.
I’ll explain what I mean by using the S&P 500. The current earnings/business yield of the S&P 500 is 4.72%. At the current level of 2,856 points for the S&P 500, the business earnings are134.8 points.
An earnings yield of 4.7% also means that expected long-term investment returns will be around that number, likely a bit higher due to inflation and economic growth. So, if you wish for safety and are happy with a 5% return, buy the S&P 500.
If you know stocks are volatile and there could be a crash coming, they you can manage your lump sum portfolio by putting portfolio exposure thresholds depending on the yield you require.
Such a strategy will allow you to be happy if stocks crash as you will be able to buy more of what you already like at a lower price. The portfolio exposure allocation depends on your personal preferences, required long term investment returns and also investing knowledge.
The most important thing when having such a strategy is that you buy more when stocks become cheaper. Thus, you will do the opposite of what most do. Stock prices will be all over the place over time, but if you know what your goal is, what are your capabilities, having such a simple plan will make investing easy and no matter what happens you will be happy.
As dividends don’t come often in most cases, dividends often seem irrelevant when compared to the daily stock market volatility of a few percentage points up or down, many disregard them. However, dividends are crucial for long term investors. If we look again at my portfolio, you can see that the yield on the whole portfolio even with the cash exposure will be around 4%.
This means that every year I’ll get at least 4% to reinvest. If stocks crash, that 4% reinvested will be of incredible importance as the returns on that will be huge. Compound that long term and you will be amazed.
Takeovers happen often and you might suddenly have 15 to 20% of your portfolio in cash. Don’t rush it, wait for good businesses to offer you the required business yield and invest when that happens.
On top of the above discussed lump sum portfolio, I have a model portfolio that I started with 10k in May 2018 where I add 1k per month.
The monthly additions cumulate over time, which means the portfolio will grow and grow no matter what happens in the market. You will also see that the cash position is much smaller at just 7%. This is because I’ll be adding 1k per month for the next 19 years and that is all the risk management I need.
When I discount all the future additions to the portfolio with a 10% discount rate for the next 19 years, the actual present value of the cash to be added is 100k. This means that the current portfolio allocation is just 20%. Therefore, if you are an investor that will still be adding money to one’s stock market portfolio, you should actually beg for a crash because your money additions, alongside the reinvested dividends, will allow you to buy more and consequently increase your long-term returns.
So, my strategy is simple, with the lump sum portfolio, I own assets where I am happy with the business yield and if the business yield increases, i.e. stocks crash, I’ll simply increase my exposure. I’ll talk about timing the markets in a moment.
On the portfolio with monthly additions, as long as you still add cash to your investments, you should not worry about a crash, but simply add money and take advantage of crashes.
Extremely important topics related to stock market crashes are the following:
Stock market crashes are not linear, something crashes while other things go up. It is enough to compare the Shanghai Composite Index with the S&P 500 Index over the last 5 years.
Over the last 5 years the Chinese stock market has experienced two bear and three bull markets while the S&P 500 was constantly in a bull market. The message is simple, stock market crashes happen all the time. Therefore, if you are diversified you can take advantage of them by buying where and when others panic.
What is also important is that not everything crashes at the same time. The S&P 500 has been down 2.6% over the last month but some stocks have jumped 26% at the same time.
So, don’t focus on the general picture, focus on the individual positions, something will go up, something will go down, just be prepared and if something is a much better bargain, buy more of the bargain.
If I look at my portfolio, the average decline from 5-year peaks is 41%. I would call that a crash.
Crashes constantly create opportunities and crashes are always around us. I wish I could time the market but all I can do is focus on the business. Market timing is dangerous.
I’ve been listening to stock market crash scenarios since 2002. “You are crazy to buy stocks now” is the sentence I mostly heard in 2002, 2009 and 2012 (European crisis) when I was buying stocks heavily. However, those that stayed away from the markets, lost a lot of money on opportunity costs.
My message is that if you focus on businesses, and on the business returns and keep a strategy like we discussed where whatever happens you are fine, you don’t have to worry about stock market crashes. This is because, let’s say you own a business that has a 15% earnings yield and the stock growth at 15% when things are going good.
Even if a recession happens every 5 years and the stock drops 30%, you will still be well ahead over 10 years. Plus, no stock will behave so linearly and you would sell when others are greedy and buy when others are fearful. Thus, your returns would be even higher. If I would have listened to recession predictions in 2018:
Source: Time 2018
I would have never bought a copper miner in 2018 because copper prices are very sensitive for economic development. However, I though that a miner was of great value and that even waiting 5 years for that value to unlock itself was a good deal. A recession didn’t happen, the stock got bought out and I did ok, despite all the doom and gloom around me.
A risk few discuss is an inflationary crash. Something not unlikely given the huge budget deficits most governments run. So, it is possible that we have an Argentina stock market scenario in the future. Something you can be prepared against only if you own value.
The Argentinian Merval index is up 34 times over the last 10 years while the peso is down about 93% against the dollar over the same period. So, $1,000 invested would now be around $2,450, something better than the S&P 500 did since 2008.
For me it is very simple as it has been rewarding me for the past 18 years. Simply buy value, good businesses, great assets and enjoy the returns while being patient.
I’ll keep looking, learning and constantly comparing in order to create the best maximizing return portfolio within my circle of competence.
The more I work, the more I am confident things will be ok. Any kind of crash would actually improve long-term returns even if it might look bad on my relative performance. However, I have no boss that can fire me based on a quarterly or yearly performance so I don’t have to fear that like most money managers have.