Money Sundays: Lessons from the Stock Market Crash

Readers, this is a post I wrote way back in late 2008 for a now-defunct website called Ironically (and not due to any brilliance on my part), the lessons and insights here are probably more valuable now than they were when I wrote it. I hope you find it useful.

With most global stock markets down 30-50% year to date, and many individual investment accounts down even more than that, now is a particularly good time to see if there are any lessons we can learn from a period that, quite frankly, has been an awful experience for almost all investors. Here are seven lessons to take away from the recent stock market crash:

1) Always be liquid

No matter how good things may seem in the market, and no matter how confident you are in your future, always keep a healthy amount of liquid assets available at all times. These assets can be in the form of cash, short-term CDs or money market funds. Ideally, this money should be in addition to a fully funded 6-12 month emergency fund. You never know when you might need extra capital for an attractive investment opportunity, to fund a large unplanned liability, or to support your family during an unexpected period of unemployment. And most importantly, you never want to be in a position where you are forced to sell your long-term investment assets during a severe market correction.

How much liquidity is the right amount? A good rule of thumb is to keep 20-30% of your investment capital in risk-free, shorter-term interest bearing investments. I also suggest people keep up to two years of expenses in readily available, liquid form.

2) Avoid catastrophic losses at all costs

If you happen to suffer losses of 50% in a mutual fund or in your retirement account (something not uncommon to many investors in 2008), a curious thing happens: in order to get back to even, you will need to double your money. And assuming an average annual return of 7% (which is looking more and more like an optimistic assumption for stock market returns going forward), doubling your money will take you roughly ten years of compounding time.

Recognize that it can take many years to claw back to break even after heavy losses. When you decide what percent of your investment dollars to allocate to stocks, particularly when you are nearing retirement age, keep this concept in the very front of your mind. During certain periods of an investor's life, stocks can be far riskier than you might think.

3) Any stock can go to zero (or close)

Before the crisis, it would have seemed laughable that a company like AIG, trading at above $70 a share with all of its enormous competitive and economic advantages, could have close brush with annihilation and have its stock nearly wiped out. And yet that is exactly what happened: the stock is down 97% from its all time high and the company's prospects are permanently impaired.

Unfortunately, this isn't as unusual an occurrence as it may seem, especially during severe bear markets. So far in 2008 alone, several airlines, a number of retailers (including Circuit City and Linens'N' Things) and more than 20 financial companies (including major names like Lehman Brothers, Bear Stearns and WaMu Bank) fell into bankruptcy. And in each of these cases, stockholders were left either with nothing or very close to nothing. As a stockholder, you are the first to be wiped out if a serious event occurs to a company in which you hold stock. Respect this fundamental risk inherent in owning stocks.

4) However, don’t let this scare you away from stocks

Are you wondering how I can talk about stocks going to zero in one breath and then encourage you to own them in the next? The reason is that you will never earn large investment gains over the long term by investing in bonds or bank CDs. Just be sure to recognize the risks involved in stock investing, especially during severe bear markets, and allocate your money to this asset class accordingly. And always remember one of the most important and ironic truths of investing: asset classes that are hated by investors now typically outperform in future periods. [Edit: note also the converse of this statement: asset classes loved by investors now typically underperform in future periods.]

5) Don’t limit yourself to “long only”

Most people invest in the stock market by owning mutual funds or holding shares in individual stocks. There's a fundamental problem with this: "long-only" investment vehicles like these only enrich investors during rising markets. I encourage you to add other investing tools to your investment toolbox so you can profit during all kinds of markets. Read up and learn how to short stocks. Learn how stock options work. Start small and gradually develop experience with these other types of investments, and you will become an all-weather investor.

6) Stay humble. Respect the unpredictable nature of the market

The sectors, markets and companies that may seem like great investment opportunities today quite often end up being grave disappointments to investors who follow the herd. Remember tech stocks in 1999? Or real estate in 2006? [Edit: Or oil stocks in 2013?] They seemed like great sectors at the time.

Markets can be highly counterintuitive, and risks are often only visible after the fact. Try to avoid consensus investment thinking, and don't fixate on the risks that are obvious to investors today. Instead, train yourself to anticipate what risks investors are likely to think about in the future.

7) Save more

I apologize for closing this essay with such an unpalatable final piece of advice, but the easiest way to make up for investment losses is to increase your personal savings. Most investors will need a combination of investment returns and aggressive savings to reach their financial goals, whether those goals are early retirement, a certain level of net worth, or a college fund for a young child. When your investment returns have been below your expectations, you can make up the difference by spending less of your income and allocating the extra savings to these longer-term goals.

We may live in a society that collectively saves and invests very little of its discretionary money, but if you save aggressively, take prudent risks, and remain mindful of the various strengths and weaknesses of stocks as an asset class, you will achieve your financial goals. Good luck!

Read Next: How To Get Balanced, Consistently Useful Expert Advice

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