Stock Crashes And Recessions Often Hurt Young Investors Most

by Hank Coleman

This is a guest post by Rob Bennett who is a journalist, the author of “Passion Saving”, and a contributor to the Motley Fool. You can find more information about his book and his blog at PassionSaving.com. To find out how to guest post on Own The Dollar, check out the site’s guest posting guidelines.

This guest post stemmed from a conversation Rob and I had over an article I wrote on GoBankingRates.com about how young investors should swing for the fence when investing early in their lives. This guest post is Rob’s response.

Young investors can take big risksThe conventional wisdom is that it is investors approaching retirement or in retirement who should be most concerned about the risks of investing in stocks. Stocks returns are volatile. If you happen to suffer a price crash near retirement, you could be dealt a mortal blow. Young investors have time to recover from a big hit and need to be in stocks because the average long-term return is so much higher for stock investors. So the argument goes.

There’s a good bit of logic behind that take on things. It certainly makes sense for investors to be more cautious after they have accumulated most of the assets they need to finance their retirements. But I believe that the conventional wisdom is rooted in an outdated understanding of the risks associated with stock investing and that there are many circumstances in which stock crashes hurt young investors more than they do those close to retirement.

The conventional take is rooted in the Buy-and-Hold Model for understanding how stock investing works, which in turn is rooted in a belief in the Efficient Market Theory, an academic construct developed by University of Chicago Professor Eugene Fama in the 1960s. Yale Professor Robert Shiller has published extensive research showing that the market is not efficient. If the market is not efficient, valuations affect (and predict) long-term returns and the Buy-and-Hold Model does not reveal the realties. That means that every aspect of our understanding of how stock investing works — including risk management — must change.

The model based on Shiller’s research — the Valuation-Informed Indexing Model — posits that stock risk is not a constant; stocks are more risky when prices are sky-high (as they were for the entire time-period from 1996 through 2008) than they are when prices are reasonable or low. This means that investors can avoid most of the risks associated with investing in stocks by being willing to lower their stock allocations when prices rise to insanely dangerous levels. Under the Shiller model, stocks are a high-risk asset class only for those following a Buy-and-Hold strategy (those sticking with the same stock allocation at all valuation levels).

Neither young nor old investors should be heavily invested in stocks at times of high valuations, according to the Valuation-Informed Indexing Model. But these two groups of investors do not suffer equally for the mistake of following a Buy-and-Hold strategy. Young investors (in many but not all circumstances) suffer more.

To understand why, you need to consider what it is that causes stocks to become insanely overpriced. Big price increases! Investors who are near retirement today have for 10 years been paying the inevitable price for the huge bull market of the late 1990s. That’s certainly a bad thing. But for these investors there is a compensating factor:

They enjoyed those bull-market gains back in the 1990s. By pushing stock prices up to crazy levels, these investors essentially moved their gains from the early 2000s to the late 1990s. The Lost Decade has been a downer for them. But the big gains of the late 1990s pushed their portfolio values up to levels far higher than what they would have been had stocks been generating their usual 6.5 percent real returns back in those days. Older investors shifted their stock-market gains, they did not miss out on them.

Now let’s consider where an investor who began investing in stocks at age 25 in the year 2000 stands today. This investor has four decades in which to accumulate enough assets to finance his retirement. One of those decades is now gone with nothing to show for it as a result of The Lost Decade.

And, in the event that stocks perform in the future anything at all as they always have in the past, it is likely that this investor will not be showing much in the way of gains for another 10 years or so. On the three earlier occasions when we permitted stock valuations to reach insanely high levels, prices fell to one-half of fair value in the wake of the huge bull market thereby created (the loss of the pretend wealth of bull markets craters entire economies). That would be a drop in stock prices of about two-thirds from where we stand today.

So the young investor may wel have lost close to 20 years of compounding returns because of the bull market of the 1990s before the consequences of the huge bull are behind us. But he did not personally experience any of the gains! Older investors frontloaded their gains. Younger investors have never experienced any gains.

The good side of all this for young investors is that, once we come to a consensus that valuations matter (this is what brings secular bear markets to a close), we will have years of wonderful returns ahead of us (the most likely annualized 10-year return starting from a time when stocks are priced at one-half fair value is 15 percent real). But how many young investors will still be heavily invested in stocks after two lost decades? Young investors’ confidence in stocks is being put to a test that older investors never experienced.

It is true that investors near retirement need to be more cautious than young investors. But it does not follow that young investors should be more heavily invested in stocks. All investors, young and old alike, should be investing more heavily in stocks when the risks of stock investing are minimal (when valuations are moderate or low) and investing less heavily in stocks when the risks of stock investing are great (when valuations are high).

At times of high prices, old investors face a particular risk that they are nearing retirement and will not be able to recover from losses. Young investors also face a particular risk — the loss of years of compounding that they need to take advantage of to be able to finance their retirements in the limited time-period available to them to do so.

(photo credit: Shutterstock)

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{ 2 comments… read them below or add one }

EasyFinanceAdvice November 7, 2010 at 11:25 pm

I would have to disagree that a recession/crash hurts younger investors the most. Mainly because young investors can take advantage of the recession/crash and buy insane amounts of stocks because they will have the time to make insane profits when the market recovers. Investors close to retirement don’t have that time…

AA November 14, 2010 at 8:53 pm

So, assuming this to be true, should younger investors move to bonds at a time like this? Or should they take a valuation approach, looking for value companies or funds, versus growth companies and funds? Would that approach allow the young investor to stay invested in your opinion?

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