A stock market crash is coming.
Is it because interest rates are at an all-time low? Is it because there’s a pandemic sweeping the globe? Is it because nearly 20% of all US Dollars in existence were created out of thin air in the last 12 months? Or is it because of some other crisis that’s affecting the world in whatever year you’re reading this article?
Maybe. But mostly it’s just because a stock market crash is always coming, eventually. And nobody knows when.
Because of its unpredictability, our investing strategy has always been to pretend that the stock market behaves randomly, with an overall upward trend in the long run. We just shovel money into broad, low-cost index funds year after year, regardless of whether the market is up or down. And it works.
But nobody should consider this strategy without also understanding its short-term risks. When stock market crashes come, they often hit hard and fast. From mid-2007 to early 2009, the US stock market lost about half its value. In October 1987, the S&P 500 dropped over 20% in a single day. There are countless other examples, and there will be more in the future.
In the long run, people who have simply bought a diverse basket of stocks and held onto them through these past crashes have done very well! But typically, the only people who are able to hold their positions steadfastly are those who understand the risks going in and know that crashes are part of the ride. We love the stock market, but if you’re not emotionally prepared for half of your money to randomly disappear, then you probably shouldn’t be all-in on stocks. So, what are the alternatives?
Note: We are not financial advisors. We’re just a couple of bloggers honestly sharing what has worked for us. This article contains personal opinions for your consideration, not professional financial advice. Check out our Disclosures page for more information.
Beyond the Stock Market
The most obvious alternative to stocks is to simply not invest your money. Here’s how that strategy has fared over the last 50 years (1971 – 2021), compared to the stock market’s wild booms and busts:
After accounting for inflation, the savings account actually didn’t grow at all. Investing in some form is pretty important for getting ahead financially. And without the passive income provided by investing, achieving financial independence (aka total freedom from your 9-5) is much more difficult (but technically not impossible).
So, what other tools are available for someone who knows they need to invest, but is uncomfortable with the idea of half their money vanishing in the stock market at the moment they might need it?
There are thousands of investments out there, but I’m gonna focus on the few that have tried-and-true historical track records: stocks, rental real estate, investment-grade bonds, and cash in a high-yield savings account.
If you have an aversion to the stock market, rental real estate is a great alternative with the potential for a similar return. Real estate prices can swing wildly just like stocks though, contrary to the common fairy tale of older generations that a home is an unshakeable investment.
It’s tough for us to buy the idea that you can never lose money on #realestate when the couple who sold our condo to us paid $105,700 (65%) less than the previous owner.— Trip Of A Lifestyle (@TOALifestyle) July 23, 2020
It’s fine to spend money on a home, but never get fooled into thinking it’s a low-risk investment.
It’s also worth noting that most real estate investments can only compete with the stock market’s high returns when they’re used as a source of rental income. Houses and land do tend to increase in value over time on their own, but on average, that increase is very slow compared to the stock market, and it’s drowned out by expenses like property taxes and insurance. If you’re not interested in landlording, a real estate investment probably isn’t a great idea.
And realize that buying real estate with the help of a mortgage is a form of leveraged investing, which amplifies its risks and rewards. If you are buying rental properties on credit rather than paying cash, you are taking on a lot of extra risk (I’ll show you an example of that toward the end of this article). Using leverage can make you richer faster, but you should only do it if you really feel comfortable with the potential downsides.
PS – If you’re into the idea of long-term travel like us, consider buying your own primary residence with rental potential in mind. If you decide to randomly jet off for 7 months, you can collect rent on your own place while you’re gone, converting it into a temporary investment property!
Anyway, since real estate isn’t any less risky than stocks, one way to actually reduce the volatility of your portfolio is to mix in some bonds. A bond is basically just a loan that you make to a big business or government, and you collect interest on that loan. The value of bonds can fluctuate as interest rates and the creditworthiness of borrowers change, but generally speaking, they are considered much safer investments than stocks and real estate.
Like stocks, there are thousands of different bonds to choose from. And also like stocks, you can just buy a total bond market index fund that contains lots of different bonds instead of picking them out individually — a way to keep investing simple and your holdings diversified.
Our favorite stock market index funds are VTI (the total US stock market) and VXUS (the total non-US stock market) — or VT (a combination of those two). When it comes to bonds, we invest in BND (the total US bond market), but you could also consider mixing in BNDX (the total non-US bond market), or just using BNDW (a combination of those two). All of these index funds are highly diversified with very low fees.
It’s worth noting that we only invest in bonds because we’re completely debt-free, including mortgages. If we carried any debt, we’d use excess cash to pay it off instead of buying bonds. It doesn’t make much sense for someone to buy a bond that yields 2% per year if they’re carrying debt of their own that costs 4% per year, for example.
Oh, and in case you’re wondering how bonds have fared historically — a one-time, $10,000 investment into a conservative 10-year US Treasury bond fund 50 years ago (in 1971) would be worth about $230,000 today (in 2021).
We have our own money spread out among all four of the major asset classes — stocks, real estate, bonds, and cash — with a heavier skew toward stocks and real estate because we’re relatively young and willing to accept the risks in exchange for higher returns.
Gut Check: A DIY Risk Assessment
Your financial freedom at any given moment in life is most accurately summarized by one number: your net worth. If you wanted to start a brand new life tomorrow, you could sell everything you own, liquidate all your investment accounts, and pay down all your debts. Whatever cash you’d be left with after this process is your net worth.
To answer the question, “how much risk is in my investment portfolio?” just ask, “how much would my net worth drop in a big economic crash?” While nobody knows for sure what the next crash will look like, it is possible to simulate what would have happened to your portfolio in past crashes. That will give you a feel for whether you’re taking on too much risk today.
The best way to do this is to analyze actual historical data. But when we’re thinking about risk in our own portfolio, a quick and dirty estimate is good enough for us. Here’s the cheat sheet we use to simulate a worst-case scenario:
You should consider the numbers in the above table to be made-up (although we did base them on some of the worst stuff that’s ever happened in market history). To tell you that we know what the next big crash will look like would be lying. But personally, we’re pretty comfortable with these worst-case hypotheticals when making our own asset allocation decisions. Feel free to adjust the numbers as you see fit.
To use this chart, just simulate this doomsday crash (examples below) on your own portfolio and see how it makes you feel. This is an emotional test, not a rigorous financial analysis. Imagine you wake up tomorrow to find that the above downturn has happened overnight**. Could you stomach it, knowing that a slow and grueling recovery was on the horizon? If not, your portfolio might be carrying too much risk.
If it was a little too easy to handle, there’s a chance you might be sitting on too much cash or other low-risk investments. Taking too little risk can result in poor long-term returns. But ultimately, this is a personal decision that is up to you, and you alone.
Let’s take a look at two example portfolios, just for fun…
34-year-old Allison has the following assets and debts:
- $3,000 in her checking account
- $20,000 in a high-yield savings account as an emergency fund
- $200,000 in her 401(k), invested in a 50-50 split of stock and bond market index funds
- A paid-off condo worth $150,000 (her primary residence)
- A $3,000 credit card balance (which she prudently pays off every month)
Her total net worth is equal to the sum of these assets, minus the debts: $370,000. Solid. Now, let’s see what would happen if a wild crash roiled global economic markets:
- Her checking account holds steady at $3,000.
- Her emergency fund still contains $20,000.
- The 401(k) balance drops to $125,000, since 15% is lopped off the bond position, and 60% is cut from its stock value.
- Her condo suffers an insane loss of 60%, bringing its market price temporarily down to $60,000***.
- She still owes that $3k on the credit card.
As the dust settles, her total net worth clocks in at a respectable $205,000. It wasn’t fun to hemorrhage that much money, but she’s probably gonna be just fine in the long run if she holds tight. Even if the crash also caused her to lose her job, she’s got $23k cash in the bank to tap before she’ll ever need to sell any investments. Assuming she keeps her living expenses in check, that could easily last an entire year or more.
29-year-old Jason has been hustling hard, working as a highly-paid mechanical engineer and buying up rental properties to increase his cashflow, all while dollar-cost averaging into the stock market for the last several years. He’s no slacker, and he’s accumulated the following:
- $7,000 in his checking account
- $50,000 in a taxable brokerage account, invested in VTI (a total US stock market index fund)
- A $140,000 rental condo with an $80,000 mortgage balance
- A rental duplex valued at $190,000, with a $100,000 mortgage balance
His total assets add up to $387,000, but he’s carrying $180,000 in mortgage debt, bringing his total net worth to $207,000. He’s doing well, and he’s making a killing on those rentals. But let’s see what happens when total disaster strikes:
- He’s still got $7,000 cash.
- The brokerage account drops by 60% to $20,000.
- The local housing market takes a dump, and his condo would only bring $56k in the now-depressed economic climate if he needed cash right now. But that mortgage balance is still sitting at $80k.
- Similarly, the duplex is underwater, with a market price of $76k and a mortgage balance still sitting at $100k.
Jason now owns assets worth a grand total of $159k, but he still owes the same $180k to the bank, putting his net worth at negative $21,000 — he’s effectively bankrupt. If his tenants can’t pay rent, or he loses his job in this economy, his rentals will be foreclosed on, and he’ll be starting from ground zero. Investing with leverage (e.g. mortgages) put him in a dangerous position that didn’t pan out very well in this case. Beware of mixing too much debt with investing.
Make Your Own Choices
The amount of risk you’re willing to take with your investments is a personal decision. Lots of experts have lots of different suggestions and rules of thumb, but ultimately, it’s a matter of preference and comfort. Sometimes, prevailing wisdom is dead wrong.
Traditional financial advisors often recommend holding a percentage of your portfolio equal to your current age in bonds, and the rest in stocks. But there are plenty of 25-year-olds who are totally comfortable holding 100% stocks. Still others would feel skittish about having more than 50% of their money in stocks. That’s okay.
Be honest with yourself, and acknowledge that taking more risk will often lead to higher long-term returns. But don’t let anyone bully you into an investment plan you don’t feel good about. And always go in with your eyes wide open to what could be — both the possible risks and potential rewards.
* Note that the converse of this statement is not always true. Accepting more risk by shifting from cash or bonds into stocks should lead to higher expected returns, but taking big risks on lesser-known alternative investments may not actually help. The relationship between risk and reward is most reliable in efficient markets of productive assets. Also, buying an individual stock instead of a total stock market index fund doesn’t necessarily increase the expected value of your investment — many times it will only serve to increase variance.
** Most crashes don’t literally happen overnight. But if you’re committed to a buy-and-hold strategy (which is a good idea), then a crash that takes a year to unfold will be just as damaging as a crash that happens in a single day. We’re just keeping things simple here.
*** Real estate fans may take issue with the idea that a house’s price could really drop 60% before seeing a recovery (it does happen). But remember that unlike stock investments, houses can cause losses outside their market price too. A sudden need for a roof replacement, a new HVAC system, or an extended vacancy in a rental property can be very damaging. Consider these types of events to be a part of this “doomsday” calculation as well. If you still don’t like it, feel free to change the numbers yourself. They’re not set in stone.