Updated: Mar 30, 2022
Taking precautions When Investing
As soon as we deviate from certainty, there is risk. If I want to be certain that I won’t be hit by a car, I stay home. But if I venture out, I know how to reduce the risk of getting hit by a car by taking precautions. Ditto with giving our kids their first phone, having family gatherings during COVID, and dating. All arguably risky endeavours but we put boundaries in place and take precautions to reduce the risks.
When we talk about the stock market, risk is the possibility that you could lose money. Is the stock market risky? Yes! Unlike the safety of a GIC, there are no guarantees and you could lose money. Is it worth venturing out into the stock market with precautions? Definitely.
Let’s set the record straight about stock market risk: although the stock market is unpredictable in the short term, over the long term its behaviour is quite reliable. The market goes up, something happens, it falls, and then it rises again. Some downturns are steeper and longer than others, but none are forever.
Why does the market always recover? The stock market is made up of hundreds of companies. These companies are real businesses: banks, railroads, retailers, utility companies, real estate companies, telecoms and so on. The companies in the S&P/TSX Composite Index (which is usually what people are talking about when they refer to the Canadian "market”) are large and well-established. They have periods when business is good, and times when business is bad, but over the long term, their earnings – and their stock prices - go up. (Of course there are exceptions.) Despite recessions, terrorist attacks, wars, and pandemics, life goes on. We still buy food, need gas for our cars, use credit cards, travel, and use a cell phone. These companies are still around selling us what we need.
There are two big reasons why the market moves up and down on a given day: sentiment and events. Sentiment is how people are feeling, be it how they are feeling about the economy, or about how pricey the market is. The other market mover is events, for example 9/11 (down), the election of Donald Trump (down then up), and the announcement of a COVID-19 vaccine (up).
Most of these events have a temporary impact on the market. After an initial reaction in stocks, there’s usually an adjustment and the market continues its (uneven) upward climb. How big and how long the adjustment is varies a lot. Sometimes it lasts a day, sometimes a decade. A big global event can make a big dent in the stock market chart and it can take years for the market to fully recover back to its prior levels.
For example, when the technology craze of the late 1990s ended, the tech bubble burst. Over the three years from 2000 to 2002, the U.S. stock market, as measured by the S&P 500 Index, fell by 40%, and investors had to wait five years for it to return to its prior levels. The financial crises saw markets fall by 38% in 2008, and took the next four years to climb back to its prior levels. The greatest market decline of them all was during the Great Depression, when the Dow Jones Industrial Average index in the U.S. fell by 80% over four years and then took 18 years to fully recover – but recover it did.
These declines are not the norm, though. The S&P 500 Index has declined in only 12 of the past 50 years, with the good years far outpacing the bad, leading to a 50-fold increase in its price over that time.
So yes, there's risk you can lose money but its more likely you will make money.
There are definitely unsafe ways to play the market. Frequent trading, or day trading as it became known during the technology craze of the 1990s is fraught with risk. Frequent trading requires people to make decisions about what stocks to buy and sell, and when. This is an impossible game to win. Even the most experienced, professional money managers with far more resources and information than the general public can’t do it consistently.
Buying just a few stocks is also highly risky. If only one of your three stocks ends up being a loser, you’ve lost a third of your money. This is especially true if you buy newly-founded companies with no track records and unproven businesses, the hallmark of day trading of the 1990s.
Here's the good news - there are two simple precautions to take: diversification, and using a buy and hold approach. Buying ETFs and/or mutual funds gives you instant diversification through exposure to hundreds or even thousands of stocks in one investment. No stock-picking required. And buying when you have the money and investing on a set schedule eliminates any guesswork around where the market is going. Beautiful!
Investing this way is liberating. By not choosing individual stocks and not trying to decide when to buy and sell you release yourself from the stress and worry of “getting it right." You don’t need to get it right. Investing is actually very, very easy.
The caveat: investing in the stock market isn’t for the money you need in the near future. If you’ll need the money at a very specific time in the next three years, don’t put it in the market. Remember how long it has taken for a market to recover after a major correction? You don’t want to be stuck selling your investments when the market has just had a really bad day. You want to have the flexibility to wait it out a bit and let the market recover. Funds for a down payment on a house? Not for the stock market. Your baby’s post-secondary tuition? Yes, in the early years, but not once your child hits mid-teens. Your retirement money? Yes.
You’re not alone if your stomach turns when you see your investment take a dive. As long as you do it right, though, it’s going to be ok. The real risk is not being in the market and letting inflation eat away at your savings. Take some time to learn about how you can invest, and get on it. It’s an investment well worth making.