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AT A FAMILY DINNER in the early 1980s, I remember one of my brothers—probably then age 20 or so—saying, “But isn’t the economy built on sand?”
My economist stepfather offered one of his trademark droll responses: “The economy’s always built on sand.”
The same could be said for the stock market. In the minds of many investors, it’s always teetering on the verge of collapse. After two years of rising share prices, and amid concerns about high stock valuations, the election, a possible recession and the Federal Reserve’s next move, that sense of unease seems especially acute right now.
Worried about a possible stock market decline? Here are five questions to ask yourself.
1. How much money will you need from your portfolio over the next five years? Historically, over most five-year periods, stocks have notched gains, even if they posted sharp losses at some point during that stretch. That’s why I typically suggest that folks get money they’ll need to withdraw from their portfolio over the next five years out of stocks and into nothing more adventurous than high-quality short-term bonds. That way, even if share prices plunge, investors should be able to sit tight and postpone any selling until share prices recover.
Indeed, when I talk to investors, I typically find they’d have no financial need to sell stocks over the next five years. Between their regular income—whether it’s from a paycheck, Social Security or a pension—and the money they have stashed in bonds and cash investments, they could easily wait out a big stock market decline. Still, there is risk—the risk these folks will make a panicky decision and dump stocks at depressed prices.
2. How much in new savings will you add to your portfolio in the years ahead? If you’re 30- or 40-years old, the biggest part of your future retirement portfolio is likely the cash you’ll invest between now and when you quit the workforce.
Let’s say you’re age 40, you have a $200,000 portfolio that’s entirely in stocks, and you’ll save $10,000 a year—or $250,000 total—between now and age 65. Arguably, your retirement nest egg is just 44% in stocks. Moreover, at least some of the money you’ll sock away over the next 25 years could be used to take advantage of stock market declines.
A key reason we’re free to invest heavily in stocks early in our adult life is our human capital—the fact that we don’t need regular income from our portfolio because we’re collecting a paycheck. As I see it, counting future savings as part of our cash holdings is one way to factor our human capital into our portfolio’s design.
3. How much of your wealth is invested in stocks? The market is a whiny child that’s forever throwing tantrums and demanding our attention. Yet, despite all the focus on the stock market’s ups and downs, it’s often a relatively small portion of many folks’ wealth.
Think of everything you own: stocks, bonds, cash investments and real estate. If you’re taking a broad view of your wealth, you might also include the value of your human capital, any business you own, Social Security, and any pension or income annuity you’re entitled to. For those who aren’t retired or close to it, their ability to earn an income is likely their most valuable asset. You might even put a value on your household possessions and the cars that you own, though I’d discourage this. These probably aren’t things you can readily sell—because you can’t reasonably live without them.
Result? Do the math, and you’ll likely find stocks are a small part of your overall wealth, and hence any market slump would put only a modest dent in how much you’re worth.
4. How much could you potentially lose in a market crash? In a bear market decline, stocks lose some 35% on average. To think about what that loss might mean in dollar terms, take the total value of your stock portfolio and multiply it by 0.35.
Would that sort of short-term loss freak you out—or would you take it in stride? I suspect most folks will find the potential dollar loss is modest relative to their total wealth. But if the possible short-term hit seems unbearably large, this is probably a good moment to dial down your stock exposure, while share prices are near their all-time high.
5. How bad is the economy? The stock market’s long-run return is driven by growth in corporate earnings, and that hinges on the economy.
If the economy contracts, and you assume it keeps shrinking for many years, it’s easy to justify a huge drop in the stock market because of the massive hit to corporations’ intrinsic value. That’s the sort of scenario that many investors—both professionals and amateurs—are apparently assuming whenever a recession looms and they think it makes sense to unload shares at 20% or 30% off. And yet, to find a stretch where we had negative economic growth for more than two calendar years in a row, you’d have to go back to the 1930s and 1940s.
What about recent decades, during which the government has been quicker to step in and help revive economic growth? The U.S. economy has been far less rocky. For instance, inflation-adjusted gross domestic product contracted 2.6% in 2009’s Great Recession and 2.2% during 2020’s pandemic. In both cases, the economy made up that lost ground the following year.
In other words, while a huge stock market decline might make sense if the economy shrank for multiple years in a row, that simply hasn’t happened in recent decades. Feeling nervous? Ignore your fellow investors—and instead pay attention to the U.S. economy’s remarkable resilience.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier articles.
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The five year investment need and retirement accounts.
I don’t “need” the money in the next five year, necessarily, but RMDs will kick in before then. Should I store an estimated amount of required distributions in cash/bonds? Or just leave it in stocks to get the growth advantage and not worry about the distribution being smaller in inevitable down years? Or take the tax hit before I reach 73 and convert the IRAs to Roth IRAs which don’t (presently) require me to withdraw an RMD annually? (acknowledging that the rules for Roths and RMDs can be changed… making planning more difficult.)
I’ve lost enthusiasm for bonds after 2022 when everything went down…
If you don’t plan to spend your RMD, I’d be inclined to keep the money in stocks and then reinvest your RMD back into stocks within your taxable account, preferably using a broad market index fund, which should be tax-efficient.
Great post, Jonathan. One point I would add is to reframe how one thinks of “stocks.” It’s very easy to view stocks as tickers on a screen or numbers on a financial statement. If you can train yourself to think of stocks as ownership in real businesses that pay dividends and reinvest profits to grow future cash flow (return on equity), you will be way ahead of the game. Btw, I have been slow to learn this lesson myself. (Warren Buffett probably learned it as a teenager.)
#3 is very important so thanks for pointing it out, Jonathan. It really puts it in perspective when someone says they are “100% in stocks.”
Nice article Jonathan. I strongly agree with list #1-4. I have to admit after decades of following the approach of ignoring market fluctuations and staying heavily invested in stocks, I have recently started to waver. My concern is mainly around your point #5 on the economy and specifically your comment “What about recent decades, during which the government has been quicker to step in and help revive economic growth? The U.S. economy has been far less rocky.” For decades I have watched the economy and the stock market shake off all sorts of temporary setbacks and march forward. Today, however, feels different. (Yes, how many times have we all heard that before.) Our national debt was $6trillion in 2000 after 224 years. Now, just 24 years later, it is $35trillion. Additionally, the Federal Reserve Balance sheet was well under $1trillion from inception until 2008. Since then it rose steadily to $9trillion in 2022, and is still at $7trillion today. In summary, there has been a massive amount of economic and stock market “influence” from fiscal spending and federal reserve actions. These actions have been in response to economic downturns in 2000, 2008 and Covid. Up until now, this massive fiscal spending and Fed action has seemed to have had only positive benefits, certainly for the stock market. (We are finally seeing some inflation impacts certainly, but those with plenty of stock market gains may hardly notice.) So what’s my point? Our government is spending in very aggressive and unprecedented ways to keep the economy humming along. Can we continue to do this with no consequences into the future? Is this just another “hurdle” the stock market will jump as it climbs the “wall of worry” into the future. Well, I don’t know. Nor does anyone else. So I guess I have to add myself to the list of “nervous investors” who are at least somewhat skeptical of the economy’s “remarkable resilience”. Have I made or will I make any portfolio changes? Everyone’s situation (age, goals, assets, etc) is different, so I will keep that to myself.
John Templeton said the 4 most dangerous words in investing are “it’s different this time”. The market will go down, and it will go up, but the government is much smarter now when it comes to dealing with it. The debt as a percent of government income is within normal range. Look it up.
I wish I could agree that the gov’t is smarter now. I worry about a president or administration that claims it would institute tariffs for the wrong reasons (as a surrogate for income tax) and would meddle with the Fed.
…and promise that essentially no one would have to pay income tax either on tips, social security etc.
“The market will go down, and it will go up, but the government is much smarter now when it comes to dealing with it.”
This may be the funniest financial line I’ve ever seen written. Thanks.
“The debt as a percent of government income is within normal range.” This statement as written has no meaning.
If you can be more clear, I’ll be happy to look it up.
As usual, a very good article. I would add, however, that our investment time horizon is also important, and for many of us, its much longer than we realize.
My wife and I are in our seventies and, given our health and family history, there is a good chance that one of us will live an additional 15-20 years. And, like many Boomers, much of what we have is tied up in tax deferred retirement accounts that will eventually pass to our son.
With potentialy a 20-30 year investment time horizon, a balanced asset allocation will likely remain a good choice.
Oh, no! It’s duck season!
As you mentioned in your first point, most HD readers are positioned to weather a market downturn or have mitigated their sequence of returns risk.
Instead of a bond or CD ladder, I invested in a portfolio of Dividend King/Aristocrat stocks. So far, we’ve been reinvesting the dividends, but it’s nice to have this as a buffer, when needed.
I was more affected by inflation over the last three years, than a market downturn. Higher current prices, plus a higher base for future costs.
Nice article Jonathan. I like the insight provided by #2 and 3 – that our wealth is often greater than we realize. It’s especially helpful for younger investors to grasp that the combination of their human capital and time / compounding are very powerful for accumulating wealth.
Yes, thanks for bringing up the fact that when we are in production mode, it is better to make the most of it and delay gratification so that the later, prime time years are not stressed by money.
However, letting young folks in on that secret is like giving a horse a pail of water when they aren’t thirsty.
I recommend another calculation regarding those short term bonds (I prefer CDs, Treasuries, high yeild savings, or money funds). Multiply by 0.88 (or 0.12 and subtract) as a simulation of high inflation. You may need to compound this over a few years.
Someone asked the great financier J.P. Morgan what the stockmarket was going to do, he replied “fluctuated”. Also, I don’t recall the source, said: “You make most of your money in a bear market, you just don’t realize it.”
Thanks, Jonathan. Good article. I wanted to make a comment about your #3 point. I agree with you about not counting personal possessions in your net worth, but if you have a second car and are in retirement or some other situations, it can be sold if you need cash. We are in the first year of our retirement and are seeing how we do sharing one car before going out to buy a second one. Also, I know I have mentioned our family member who has ALS in the forum and his wife is selling his car b/c he is at the stage of his disease where he will not need it anymore and they can use the cash. Chris
Insightful perspective as usual Jonathan. After reading this I performed some back of the envelope (actually used the internet and a calculator) to see where we sit based on your information.
As I have written we are utilizing our portfolio to pay for living expenses while we delay claiming Social Security at 70. I have an admittingly random portfolio value at which time if met would trigger us claiming my wife’s lower value SS payment (we are both just past full retirement age) in order to decrease the need to take withdrawals from our portfolio to meet our spending needs. I performed the calculation you recommend and under that scenario it is unlikely we will hit the mental trigger point which is reassuring.
We also have 2 years of cash and an additional 8 years of mostly short term, and short term tips per Christine Benz’s bucket portfolio recommendations.
With this article Jonathan you have provided me with a perspective which will allow me to sleep better.
Thanks again!
In South Africa, we don’t have social security; those who save rely mainly on tax-advantaged employer and individual retirement funds. I list those on my personal balance sheet, even though these can (and sometimes must) be converted into a type of annuity at retirement.
US Social Security is effectively an annuity with a defined benefit. These future cash flows have a present value. Yet somehow Americans don’t seem to put a capital value on this benefit, and record it as an asset. Surely, doing so would lower their balance sheet volatility and stock market angst?
Valuing ones Social Security, (as well as defined benefit pension income) in order to reduce market angst is a pretty good idea, even for many retirees. Dividing the annual sum of our benefits by .04 and adding that sum to our IRA balances probably lowers our exposure to the market to around 20%. It helps that SS covers our entire budget at the current time.
Jonathan, here’s a question for you regarding #1. I like your recommendation to hold most income generating funds in tax protected accounts. (I can’t find the link to share with others, but as you’ve explained, if one wants a big chunk of cash, they can sell stocks in a taxable account and buy in a tax protected account, keeping their overall allocation unchanged.) Following this strategy, almost all of our cash and bonds are inside protected wrappers.
Would you say this recommendation applies not only to one’s strategic cash/bond allocation, but also for any amount needed for spending? It seems to me like it should. While it’s perhaps psychologically comforting to have what you might need to spend already in the spending account, following the strategy and selling stocks in a down market even next week seems fine as long as you’re ready to buy fallen stocks inside the IRA/401k at the same time you sell them outside it.
Would you agree?
Yes, I agree. All this should work fine as long as you aren’t constrained by tax penalties from pulling money from your IRA or old 401(k).
This is the section of the money guide you’re referring to.
Thanks Jonathan. I’m not sure I understand your caveat:
“as long as you aren’t constrained by tax penalties from pulling money from your IRA or old 401(k).”
Why would this be a concern? Within the IRA/401k we’re just talking about exchange from one investment to another; nothing is coming out.
Sorry, I should have been clearer: Holding bonds and cash in a retirement account, while holding stocks in your taxable account, works well — as long as your cash needs aren’t greater than the sum you have in your taxable account. If they are, you then have to consider pulling money directly from your retirement account, at which point tax penalties become an issue.
Got it now, thanks again.