Price Drops Are Good for Young Investors in the Stock Market

This is a guest post by Rob Bennett, the author of Passion Saving; The Path the Plentiful Free Time and Soul-Satisfying Work. You can read more at the Passion Saving website.

I’ve spoken to a good number of investors in their 20s and 30s who are concerned about the poor performance of U.S. stocks in recent years. How are they going to accumulate the assets needed to finance a retirement when stock prices are no longer moving upward?

The problem is to a large extent an illusion. If you were planning to buy a new car soon and you were reading in the papers that car prices were headed downward, would you see that as a good thing or a bad thing? Well, it works the same way with stocks. Investors in their 20s and 30s will be putting a lot of money into stocks in coming years. They will end up better off if prices come down than they will if prices go up.

In fact, prices must come down if we ever again are to see the sorts of returns from stocks that allowed earlier generations to use stock investing as their path to secure retirements. Stocks have never provided strong long-term returns going forward from the sorts of prices that apply today. What has always happened in the past is that stock prices have come down hard from these price levels. After the big price drops, stocks were again positioned to provide an outstanding long-term value proposition.

Stock Return Calculator

I am the co-developer (with John Walter Russell) of a calculator that tells you what you need to know to tell if stocks are priced well or not. It’s called “The Stock-Return Predictor” and it employs a regression analysis of the historical stock-return data to let you know the likely annualized real return of stocks starting from all possible valuation levels. You’ll see from spending a little time with the calculator that stocks are an entirely different asset class when they are priced as they are today compared to when more reasonable price levels apply.

Today’s P/E10 (that’s the price of the S&P 500 index over the average of the past 10 years of earnings) is 25. The most likely 10-year return is only 1.55 percent. You can probably do as well or perhaps even a bit better in far safer asset classes.

But look at what happens when the P/E10 level drops to 14, the fair- value price. The most likely 10-year return jumps to 6.34 percent. If the P/E10 level drops to 8, which is what normally happens in the wake of a huge bull market, the most likely 10-year return jumps to 14.51. All of your concerns about financing a retirement disappear after a hard price drop!

We need a big price drop. We need one badly.

The reason why price drops make many of today’s investors anxious is that we were told so often during the huge bull that stocks are always the best investment for the long run and most of us are wildly overinvested in stocks today as a result. The answer is to learn how valuations affect long-term stock returns, to lower our stock allocations to more reasonable levels, and to come to appreciate the long-term benefits that come from big price drops starting from the sorts of price levels that apply today.

You’ll view big price drops very differently when your stock allocation is lower. Those with reasonable stock allocations are able to see that low stock prices are the key to long-term wealth accumulation.

Rob Bennett is the author of Passion Saving; The Path the Plentiful Free Time and Soul-Satisfying Work.  His Stock-Return Predictor calculator is available at the PassionSaving.com web site.

Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

19 comments
kevindagnycu
kevindagnycu

Hallo! Is there anybody here to tell me how much time have we got left till the end of the lesson?

ErordalgE
ErordalgE

Hi

As a fresh genxfinance.com user i just want to say hi to everyone else who uses this board :D

Rob Bennett
Rob Bennett

I say this only to warn those who don’t know your reputation and work.

It certainly is true that people need to check out both sides of the story, Thanker. I'm some guy who posts stuff on the internet. It would make me sick to think that there was somebody out there who had changed his or her investing strategy based solely on something I said. On the other hand, it also troubles me that there are some going with the Passive Investing idea without having checked that one out carefully enough. We all need to be more than a little skeptical of what we pick up from materials we rely on to help us decide what to do with our retirement money.

Otherwise, I don’t spend my time bandying words with nuts.

Let it out and let it in, Thanker. All of us humans are a little nuts from time to time. I am. You are. Robert Shiller is. John Bogle is. All of the humans. It's the way we were made and there's no getting around it. The trouble starts when some of us come to think that perhaps we're above all that.

Rob the Nut

thanker
thanker

Sure. Your "stock return predictor" has repeatedly been shown to be the result of poor financial knowledge combined with invalid mathematical analyses. (Readers: don't take my word for it. Google "Rob Bennett financial adviser".)

I say this only to warn those who don't know your reputation and work. Otherwise, I don't spend my time bandying words with nuts.

Rob Bennett
Rob Bennett

Do you have any thoughts on the subject matter of the blog entry, Thanker?

Rob

thanker
thanker

CAVEAT EMPTOR! Rob Bennett is a notorious internet crank who's advice has repeatedly shown to be bogus. Don't take my word for it - simply google "Rob Bennett financial adviser".

Rob Bennett
Rob Bennett

Rob has been thoroughly debunked.

There are some who say that. But most who say it also say that long-term timing has been debunked. Has it?

It's become unpopular during the longest and strongest bull market in the history of the United States, that much is fair to say. But then long-term timing always becomes unpopular when prices reach the levels that apply today. And it always becomes popular again when prices drop hard, as they must if the markets are to continue to function.

Stocks are like any other asset that can be bought or sold. They offer a stronger value proposition when purchased at reasonable prices. The negative reaction you often hear in response to that claim at times of high prices is an emotional reaction.

Rob

HF Markets
HF Markets

Sound advice. There are many investors who are staying away from the markets when there are opportuities for ong term bargains. You did a great article on Dollar cost averaging, now is great time to start.

Rob Bennett
Rob Bennett

The idea that valuations affect long-term returns has been around since the first market opened for business. It is always "forgotten" by many when prices get to the sorts of levels that apply today.

It is true that there are some who do not like hearing this reality discussed at the times when it is most important that it be discussed. It is also true that there have been thousands of members of the Retire Early/Indexing communities who have expressed interest in having open discussions and learning more.

Here is a link to an article at my site containing 101 snippets of community members who expressed a desire to be able to learn more:

http://www.passionsaving.com/investing-discussion-boards.html

I will continue to do what I can to help these people learn what they are seeking to learn. It's exciting stuff and it's a good feeling learning together what we need to learn to achieve financial freedom earlier in life than would otherwise be possible.

Rob

Rob Bennett
Rob Bennett

David is also correct that "we may not see those historic low P/E ratios again." My personal belief is that we will see them again. But it's always a good idea to consider more than one point of view on a question like this.

My view is that investing is a probabilities game. I am highly confident that we will return to moderate price levels. I believe it is more likely than not that we will see low price levels in days to come, but the odds on this are certainly not as great as the odds that we will see moderate price levels.

The strategic implication is that it is a mistake to try to pick the market bottom. I recommend that most investors keep a small percentage of their portfolios in stocks even at today's price levels. But I do not recommend that people wait until we see very low price levels to up their stock allocations. Once the likely long-term return rises to a level where stocks offer a better long-term value proposition that the alternative asset classes, it makes sense to increase your stock allocation, in my view. Those who try to get too cute usually end up hurting themselves by doing so.

Rob

Rob Bennett
Rob Bennett

Thanks to all who commented.

Beyond Paycheck to Paycheck is correct. I do indeed advocate market timing.

The historical stock-return data provides strong evidence that short-term timing (changing your stock allocation in response to price changes with the thought that you will see benefits for doing so within a year or so) does not work. That same data also provides strong evidence that long-term timing (doing the same with the thought that you will see benefits for doing so within five or ten years) does work.

The purpose of the calculator is to provide people with the information they need to engage in long-term timing effectively.

Rob

David
David

We may not see those historic, low PE ratios again because earning forcasting is much better now. Investors are willing to pay more for companies with big earning upsides. While in the past it was 'What have you done', it is now 'What are you going to do in the future'.

Beyond Paycheck to Paycheck
Beyond Paycheck to Paycheck

Agree with the premise and all the comments so far, but the original poster is (in a not so subtle way) advocating market timing. There's an inherent contradiction here: you can't take advantage of lower prices through dollar cost averaging long-term investing philosophy if you're waiting for the "Stock market predictor" to tell you what to do. Thanks, but I'll pass.

Jeremy
Jeremy

It is odd how people will go out of their way to buy something on sale, or cheap, yet when it comes to investments, they do just the opposite. Prices go down, and some people sell. When prices go up, they regain confidence and then buy again.

I think a lot of it has to do with the fact that people get regular statements and can go online and check their balance at any time. Think about it. If your car or house had an absolute value tied to it and you received regular statements showing its value, you'd have people freaking out about those items as well.

Instead, when you get that piece of paper that says your account is worth X dollars, it is easy to equate that to cash and think that because it has gone down in value, you need to make drastic changes. It is hard for most people to rationalize otherwise.

Fern
Fern

I agree; people just don't recognize it for the buying opportunity it is. I'm in my late 40s and am confident I still have plenty of time to ride out the bear market and keep on buying.

Mrs. Micah
Mrs. Micah

I've been trying to see it that way. I'm going to be in the market for years (unless I die, in which case I won't need retirement funds). And going with the market seems achievable through indexes. I don't trust anyone's ability to beat it, except perhaps Buffet. So that's what I'm best off doing. And if I buy some during a dip, it'll offset what I buy later at a high price. Goal is to sell it all higher. :)