You only change under one circumstance: when the discomfort of remaining the same exceeds the discomfort of changing.
Market dips & crashes erase overconfidence, instill humility, and distinguish the speculators from the investors.
Crashes are therefore an opportunity to become a better investor. My most memorable lessons come from my mistakes that resulted in loss.
Pain is interesting – it etches lessons in memory.
The education that comes from pain cannot be replicated by this blog, a podcast, or any formal education.
Even if you don’t make mistakes during a crash, your journey through discomfort will breed confidence to help you better endure future turmoil.
Here are 5 reasons why a stock market crash may be good for you.
My aim is to help you embrace, rather than run from, market crashes. This way, you can stick around to reap the amazing long-term compounded returns that the market can offer.
Table of Contents
Reason #1: Dividend Yields Rise During a Market Crash
A stock represents ownership of a business. As a business owner, you get to share in the earnings of the business.
A dividend is one method of sharing these earnings. These are cash payments to you, normally made four times per year.
The “dividend yield” is the fraction of the share price, measured in %, that is paid out annually in cash. The table below shows how the dividend yield can change with a falling share price, assuming the dividend remains unchanged.
| Share Price | Annual Dividend | Dividend Yield |
|
$100 |
$3 |
3% |
|
$75 |
$3 |
4% |
|
$50 |
$3 |
6% |
Why did I keep the annual dividend stable during a crash? Dividends tend to be very stable relative to stock price prices swing more widely than earnings. In addition, businesses can draw from cash to pay dividends.
High dividend stability relative to prices results in an increased dividend yield during price drops.
For example, BMO’s stock dropped by 38% in April 2020 when COVID hit. But BMO’s dividend amount remained unchanged, so the dividend yield rose from ~4% to over 6%.
BMO continued to increase its dividend in 2021. Eventually, the stock price caught up.
Why Should Index Investors Care?
Index investors also benefit from rising index dividends during a crash. The dividend of an index reflects the (weighted) average dividend of all the hundreds or thousands of companies that make up the index.
As the market crashes, the group of stocks that make up an index fall in price, but their dividends remain relatively constant. Therefore, the index dividend goes up.
You can read more about why index funds are awesome here.
Reason #2: Crashes Increase Expected Future Returns
I firmly believe all investors should understand the source of stock returns. Long term stock market returns come from two places:
- Dividends.
- Earnings Growth.
In addition to earnings growth and dividends, we have changes in valuations. Changes to valuations are driven by investor sentiment, so they’re impossible to predict.
Further, changes to valuations should be expected to average out to zero over the course of 30+ years.
Long Term Stock Returns = Earnings Growth + Dividend Yield
Short Term Stock Returns = Earnings Growth + Dividend Yield + Changes in Valuation
When markets crash, valuations drop while dividends remain relatively stable. Higher dividend yields increase future expected returns.
And since valuations dropped during the crash, you can also expect a higher short-term return as valuations re-bound upwards.
The Source of Stock Returns is Grounding
Understanding the basis for investment returns flips your perspective on market crashes. It allows you to view crashes as an opportunity rather than a catastrophe.
This grounding reality can limit emotional decision making, help you sleep better at night. It improves your willingness to take risk – I’ll discuss this below.
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Reason #3: Market Crashes Help You Understand and Control Your Human Biases
A market crash is an opportunity to reflect on your human biases. What emotional pulls did you feel before, during, and after the crash?
How did you respond to these natural emotional pulls?
Rapid financial loss triggers strong emotions that motivate wealth-destroying actions. Your emotions tell you to do exactly the opposite of what is best when investing. A bit unfortunate.
Let’s cover our feelings, and the unfortunate actions they incentivize during the standard phases of market swings:
- The Lead Up to the Crash
- During The Crash
- The Recovery
Lead Up To The Crash: Overconfidence
It’s normally a great time before a crash. There are hot stocks and industries, and everyone is making good returns.
The news, social media, and Reddit accelerate the spread of positive sentiment, triggering our conformance biases (herding) and Fear of Missing Out (FOMO). Investor overconfidence builds.
Most of us started investing over the past decade – a time when stocks have provided wild returns.
I believe the bull market from 2009-to 2022 has produced a generation of overconfident investors with unrealistic expectations of future performance.
During The Crash: Loss Aversion
This is where investors get humbled.
Humans are biologically wired to avoid loss. Losing water, food or friends 10,000 years ago would result in death. Whereas gaining water, food or friends made us marginally better.
Our loss aversion motivate us to panic sell investments at the worst time. The bottom of a crash is when emotions run high, pain is strong, and expected future returns are highest.
The Recovery: Reflect and Learn From Failure
Let’s consider Joe, an investor driven by his emotions. Leading up to a crash, Joe is excited due to high recent returns and feels confident – overconfident.
As the market tumbles, Joe starts to panic. He sells all of his investments out of fear.
Now Joe holds while the market recovers to new all-time highs. Joe has lost money during his investing experience and missed the recovery.
Joe has three options during and after the recovery:
- Self-reflect on his behavior and make changes (hard).
- Skip the self-reflection (easy) and repeat the same mistakes.
- Skip self-reflection (easy) and never invest again. Joe will become resentful in this case.
Option two and three are easy in the short term, but hard in the long term. Option #1 requires Self-Discipline: The Key to Building Wealth.
Portfolio Size and Human Biases
The size of our portfolio drives the intensity of the emotional pain during market crashes.
Intensity of emotional pain is a function of portfolio size relative to income. I’ll show you what I’m saying by taking a look at our friend George.
We will consider George, an index investor (George is smart) who makes $5,000 per month. We will assume the global stock market crashes by 40%.
Let’s see how his portfolio size affects the total loss relative to income.
Portfolio Size | Paper Investment Loss | Time Value of Pre-Tax Income Lost |
$10,000 | $4,000 | 0.8 Months |
$50,000 | $20,000 | 4 Months |
$100,000 | $40,000 | 8 Months |
$200,000 | $80,000 | 1.3 Years |
| $500,000 | $200,000 | 3.3 Years |
A loss of $4,000 doesn’t cause George much pain, because he can easily recoup this in a few months of savings generated by his work. But this story changes when his portfolio gets larger.
With years of investment growth, George has a $500,000 portfolio.
A 40% loss is now equivalent to 3.3 years of pre-tax income. George would have to work for over 8+ years after taxes to recoup that loss.
The desire to panic sell and make emotional decisions grows stronger as your portfolio grows in size. It therefore becomes more important to keep your biases in check as you age as an investor.
Reason #4: Market Crashes Help You Understand Your Unique Risk Tolerance
What is Risk Tolerance
Your risk tolerance is a measure of how much temporary loss you can endure. Risk tolerance is a combination of your willingness to take risk and your ability to take risk,
Ability to take risk is based on the state of your life, such as age, time horizon, and income stability.
Willingness to take risk is how well you sleep at night and your ability to understand and tame your emotional biases.
Most people under 45 years old are limited by their willingness to take risk due to emotional discomfort in the face of loss. Folks in this age category (<45 years old) often have a high ability to take risk.
Learn more about investment risk and risk tolerance in this intro post on investment risk.
Assessing Your Risk Tolerance
Risk tolerance problems don’t bubble up until there is a crash. A market crash is an opportunity to reassess your risk tolerance.
Symptoms of taking on too much risk include:
- Panic selling during the crash
- Selling at a loss because you need to fund a mandatory purchase – this is why it is key to hold an emergency fund.
- Sleeping poorly at night due to market turmoil.
All it takes is a couple of behavioral errors to hurt long-term investors. Even 4000 years ago, the wise ones stressed the preservation of capital over returns. A decade of market-beating returns is irrelevant if you erase your wealth with one bad decision.
We haven’t seen a real crash since 2008. The COVID crash was a fairly painless blip. Therefore, I think many investors are taking too much investment risk without knowing it.
Risk Tolerance Lessons Learned
A crash gives you information about your willingness to take risk. If you make a mistake, it may also teach you about your ability to take risk.
Now that you understand your risk tolerance, you can engineer your investment risk to match. Maybe you need to reduce risk by adding bonds, or perhaps a 100% equity portfolio is okay, but you need to diversify.
Portfolio risk can be engineered by altering the asset mix between stocks and bonds. This mix is called your “asset allocation”.
A proper asset allocation will help you sleep better at night and meet your financial goals. The Vanguard investor questionnaire is a good starting point to estimate this asset allocation.
It can be difficult to endure the emotional rollercoaster alone. Hence why many financial advisors have their own financial advisors. A financial advisor can be grounding during market crashes.
Reason #5: Crashes Improve Your Investing Systems
Maybe you attempted to “time” the market and did not have a systematic way of investing. Or maybe you didn’t have a defined asset allocation as described in #4 of this post.
Investing systems solve these problems.
I view investing systems in two steps: (1) the system initial setup, (2) implementing the system, (3) improving the system. Repeat.
An example is helpful here, so I’ll share my basic investing systems. Here is the setup:
- Understand why globally diversified index funds provide the highest risk-adjusted returns.
- Set total risk tolerance by defining ability and willingness to take risk.
- Set a target asset allocation that aligns with my risk tolerance. For me, this is 100% stocks.
- Identify the specific index ETFs or index mutual funds to invest in and set a target allocation. I target 25% in Canadian Stocks, 25 % in U.S. Stocks, 16% in International Stocks.
Now that we set up the system, here is my system execution:
- Invest savings into the target asset allocation at set intervals, regardless of what the market is doing. My set interval is every two months.
- Rebalance twice per year to meet the target allocation from the system setup.
- Do this for the next 20+ years.
Investing System Errors
Crashes provide an opportunity to identify and fix the following errors in system setup and system execution:
- Not having a target investment allocation to stocks and bonds based on your unique risk tolerance. System setup error.
- Not setting a target allocation to the different geographies: Canada, U.S, International, and Emerging Markets stocks. System setup error.
- Not having a pre-determined interval of investing. Perhaps every paycheck, every month or every two months. System Execution Error.
Conclusion
Market crashes are painful. Thankfully, pain motivates deep reflection and change. Assessment and application of lessons learned improve investing competence.
You can better define your risk tolerance, better understand and control your human biases and improve your investing systems.
In turn, your future investing experience will be less stressful and your confidence improved.
Market crashes are great for young investors.
2 thoughts on “5 Reasons Why A Stock Market Crash May Be Good For You”
I like the denial, panic and fear chart as it is oh so true. Thanks for this it is a great resource.
The most difficult and critical trait of long-term investors is the ability to control those emotions!
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