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Enrich Your Future 25: Stock Crashes Happen—Be Prepared

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 25: Battles are Won Before They Are Fought.

LEARNING: Be well-prepared for potential disruptions in the market.

“Many investors let emotions drive their decisions, and they end up buying high and selling low—the opposite of what you are doing when rebalancing.”

Larry Swedroe

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 25: Battles are Won Before They Are Fought.

Chapter 25: Battles Are Won Before They Are Fought

In this chapter, Larry emphasizes the importance of strategic planning to anticipate market shocks, which occur approximately once every three or four years. This proactive approach ensures that investors are well-prepared for potential disruptions in the market.

Historical distribution of stock returns

Gene Fama studied the historical distribution of stock returns and found that the population of price changes if it was strictly normal on any stock, then a standard deviation shift from the mean of five standard deviations should occur about once every 7,000 years.

The reality, though, is it occurs about once every three or four years in the US equity markets. That means the distribution of returns is not normally distributed. To illustrate this, Larry shares evidence of big fat tails in the distribution. From 1926–2022, in 26 out of the 97 years, the S&P 500 Index produced negative returns. In 11 of those years, the losses were greater than 10%. In six of the years, the losses exceeded 20%. In three of the years, the losses exceeded 30%. In one year, the loss exceeded 40%.

Prepare to live through a big market downturn

According to Larry, the data unequivocally shows that stocks are risky assets, with risks that are more prevalent than historical volatility would suggest. Investors must be prepared to face severe losses at some point. It’s not a matter of if these risks will manifest, but when, how sharp the declines will be, and when they will subside.

For investors, Larry underscores the importance of winning the big fat tails battle in the planning stage. Successful investors know that bear markets will happen and that they cannot be predicted with a high degree of accuracy. Thus, they build bear markets into their plans. They determine their ability, willingness, and need to take risks.

Larry notes that, on average, prudent investors prepare to live through a big market shock once every three or four years. They ensure that their asset allocation does not cause them to take so much risk that when a bear market inevitably shows up, they might sell in a panic. They also make sure that they don’t take so much risk that they lose sleep when emotions caused by bear markets run high.

The best way to invest during crises

While global diversification across equity asset classes is a prudent strategy that reduces risk over the long term, this benefit diminishes during crises. The only reliable refuge during such periods is high-quality fixed-income investments, such as Treasuries, government agency securities, and FDIC-insured CDs. This emphasis on diversification should instill a sense of security and protection in investors.

Riskier fixed-income assets such as junk and emerging market bonds also suffer from flights-to-quality and liquidity. This is why the prudent strategy is to ensure that your portfolio contains a sufficient amount of safe bonds to dampen the overall portfolio’s risk to an acceptable level—winning the battle before the fight begins.

Enrich Your Future 25: Stock Crashes Happen—Be Prepared

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