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Why Do Markets at All Time Highs Mean a Crash Is Coming? Don’t Stocks Have to Go Up to Be Worthwhile?

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As soon as markets start to go up and stay up for a few months in a row, someone starts predicting that they will crash. And when the TSX and NYSE hit new “record highs” the buzz became almost deafening: Now a MAJOR market meltdown was inevitable–it was just a matter of when. But why? Why do people assume that markets reaching all time highs mean a crash is coming: if the stock market is supposed to return an 8% or higher average, doesn’t it mean it MUST set new records and fairly steadily?

Why Does Anyone Invest in the Stock Market?

Investing for Income

Some people invest in companies listed on the stock markets to get dividends and distributions. Their investment choices are driven by a need for income.

Not all companies offer dividends or distributions though. Why would people buy shares in those companies?

Investing for Capital Gains

Many other people are investing in companies’ stocks to try to win a capital gain. They want to pay $20 for a share and sell it to someone else for $40, or more. They are willing to buy shares that don’t pay anything to investors but which may be worth more in the future than they are now.

Obviously, sometimes these investors are unlucky. The perceived value of the company drops and if they sell their shares they realize a capital loss.

Shouldn’t the Stock Markets Indices, Over Time, Go Up?

If you go to a site like Yahoo Canada finance, or sign in to a brokerage website, you should be able to look at a graph of the S&P TSX Composite Index over several years. Go to https://ca.finance.yahoo.com/q/bc?s=^GSPTSE&t=my&l=on&z=l&q=l&c= and if necessary click on: Max

It should have jagged peaks up and sharp valleys down, but there should still be an overall trend in an upwards direction. Or at least there should be if you believe that investing in the stock market should yield you a capital gain, over time, if you invest a tiny bit in every company in that market index.

If you look at the last 10 years of the S&P TSX Composite, you will likely notice it spiked up to a nice point at about 14 000 in 2011 and it’s currently (in September 2014) at 15 000 and still climbing. In 2008 it also reached over 15 000. On January 1, 1985 it was under 3 000.

The overall trend from 1985 till now is up.

So why, just because we are finally trading in the 15 000 plus range, are people shouting it’s going to crash?

For people who had all of their money invested before May 2008, and who invested for capital gains not for dividends or distributions, it must seem like the party is just about to start. For years they’ve waited patiently, pocketing any useful distributions and dividends, but biding their time waiting for some big ticket capital gains.

Unless there’s some “invisible ceiling” at just over 15 000 why should anyone be panicking?

Doesn’t Couch Potato Index Investing preach that you don’t try to time the market, you just buy steadily and hang on for the ride? I’ve never read an index investing article that said there is a maximum the market is allowed to rise.

Why I Am Still Investing a Bit a Month Every Month Into the Index Funds Mirroring the Stock Markets

I’m not the usual type of investor. I’m very conservative and very risk averse. So my portfolio stands on a wide, thick platform of fixed income securities. Enough, in fact, to provide a modest retirement income if all of our other investments failed.

Most of our new money, however, is going into the equity markets.

We are still vacillating about whether to invest the majority of it into income-generating investments or into “buy the entire market” index investments.

While we are deciding, we are putting some of our new investment funds into both. It’s wishy washy but it beats having everything sitting in cash.

So every month, we put a bit more into the stock market in the form of “buy the entire market” “ultra low fee” ETFs.

And I don’t see any reason to stop doing that just because the markets are at “all time highs.” If they never pass today’s “all time high” then there is no actual capital gain ever to be made by investing in index funds. A whole branch of the investing industry is mistaken. They will all lose money and never be able to speak on CTV or CBC again.

That seems unlikely to me. Yes, there may be a market pullback or even a radical plummet. But if you believe that capital gains can be made by investing in an index-matching-style then sooner or later, the money you invested in an index should return to parity and should, ultimately, increase in value.

I don’t like the uncertainty. I don’t like wondering if I might be buying just at the time when the rug is about to be pulled and the market will tumble into a trench it will take years to climb back out of. But that’s the uncertainty I have to accept if I want to invest in index-linked products in order to (theoretically) capture some capital gains worth more per dollar invested than my fixed income investments can yield.

Wish me luck!

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Do you index or couch potato invest? Do you have faith that the S&P TSX Composite must eventually keep rising about 15 000 and in fact above 16, 17, 18, 19 and even 20 000? Or are you selling out, buying food and ammo, and building a bunker out of gold bricks? Please share your views with a comment.

Why Couch Potato Investing Doesn’t Work

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Why Couch Potato Investing Doesn’t Work …
… For Everyone

Sorry but I couldn’t resist a trick title like that: It’s Friday; It’s overcast; It’s been raining and cold all week so few warblers are bothering to move: I’ve got to have something to smile about. However, today I will argue that for some people Couch Potato investing, also known as index investing, does not work.

What Do I Mean by Couch Potato or Index Investing?

There are several different investing methods that get lumped together under the heading index investing or Couch Potato investing. There is an absolutely fantastic website about this type of investing run by the Canadian Couch Potato at http://canadiancouchpotato.com/ for those of you who would like more information.

What I’m discussing here is a “basic” Couch Potato method of investing:
You invest in 4 types of ultra-low-cost ETFs:

  • A Canadian equity fund that matches an extremely broad and diversified Canadian index
  • A US equity fund that matches an extremely broad and diversified US index
  • A Foreign (non-US, non-Canadian) equity fund that tries to capture a broad swath of the businesses listed on the various international stock exchanges
  • A bond fund (often one with a short term-to-maturity and a mixture of government and corporate high quality bonds)

The percentage invested in each of the 4 ETFs could vary but a common split would be 20% Canadian; 20% American; 20% Foreign; 40% Bonds.

You split your money and invest it at the correct percentage in the 4 different ETFs.

Monthly, quarterly or semi-annually you add new contributions proportionately.

Once a year, you re-balance the portfolio to keep your asset allocations at 20/20/20/40. This could be done by buying more of the class that has dropped with your new contribution or by selling some of your excess units and buying more of your missing units. (E.g. if your allocation has become 30/10/20/40, you would sell some of the 30% ETF and buy more of the 10% ETF.)

You keep doing this for 10-50 years.

You do NOT sell your ETFs randomly just because the stock market is going up or down, only annually if you need to re-balance.

You do NOT invest extra in one of the 4 ETFs just because “it’s on a roll” and you want to make some extra money quickly.

Why Does Couch Potato Investing Work?

This type of index investing works because it takes all of the guess work, timing and emotion out of investing.

It’s based on the theory that over time the value of money invested in the stock markets and bonds will increase so if you invest in them and stay invested at all times, the value of your investments will increase.

Some will argue that you will even earn the most by investing in this way. That gets way too complicated for me to be interested in, but it is generally agreed by everyone that it is a very good way to invest which should result in an increased value of your savings over time.

I keep saying “over time” because at any one MOMENT in time, the value of your investments may NOT be higher. And that’s the problem.

Couch Potato Index Investing Does Not Work for Everyone

The reason couch potato index investing does not work for everyone is that not everyone can stick to it.

Some people cannot accept seeing large decreases in the value of their investments.

Other people cannot accept seeing investments not increase in value over several months or even years.

For example, following a simple Couch Potato portfolio, an investor might put 20% of their money into an International equity ETF. Let’s say they invested $10,000.

During a nasty period of market upheaval, they may see the value reported for their investment in that ETF drop to $7000.

To be a proper Couch Potato investor they must

  • Shrug and ignore it, until
  • during their yearly asset allocation re-balancing time
  • when they must either sell some of their other ETFs to bring the percentage back up to 20% of their portfolio, or
    invest new money in this ETF until it comes back up to 20% of their portfolio.

That’s right: They have to sell their “winner” and buy more of their “loser”; or put more new money into their “loser.”

Because it’s not really a “loser.” It’s just an ETF that has dropped in value. Over time, lots of time, the Couch Potato philosophy says that it will go back up in value and in fact increase in value over the starting value. So by re-balancing, the investor is actually buying more of a “bargain” ETF not a “loser” ETF. And doesn’t everyone like to buy a bargain?

Some people, though, just cannot handle this. At best they will ignore this drop in value of the international ETF and refuse to rebalance their asset allocation annually. At worst they will sell out of their entire position in this international ETF “dog” and put the money into something else.

Either way, they are no longer investing in the Couch Potato Index style.

They are not likely to succeed as a Couch Potato investor because they are ignoring the simple, basic rules that make this style work.

How Can I Decide If I Can Succeed as a Couch Potato Index Investor?

It’s really not possible to be sure how you will react to a dizzying drop in the value of an ETF until it happens. However, you can ask yourself some tough questions to get a glimpse of how you might feel.

The internet is full of great charts.

https://ca.finance.yahoo.com/echarts?s=^GSPTSE
is a link to a Yahoo chart of the value of the S&P TSX Composite Canadian index. If you click on the Max link under the chart, you will see how it has behaved for many years.

https://ca.finance.yahoo.com/echarts?s=SPY#symbol=SPY;range=my
is a link to a Yahoo chart of the value of the SPDR S&P 500 NYSE. If you click on the Max link under the chart, you will see how it has behaved for many years.

It’s not just important to look at those sharp drops.

It’s also important to look at the width between two points at the same height. The width is how many months or years it took for the index to return to the SAME value. Not to increase, just to return to where it was.

Photo of TSX simplified chart

Looking at the Yahoo TSX chart, if you bought units in a matching index fund only in August 2000, you’d have had to patiently wait until about December 2005 just to *break even*. (Dividends will help a bit but not as much as you might think if you buy a “most of the TSX” ETF. Many TSX stocks pay almost nothing in dividends.)

Similarly, if you bought in only at June 2008, you’d have to wait till February 2011 to break even and even then it would go down again only rebounding by September 2013.

If you bought in only during April 2011, you would only have broken even in October 2013.

Image of SPDR 500 simplified chart

The SPDR S&P 500 chart also shows the need for patience. Someone who bought only in September 2007 had to wait till early 2013 just to break even.

NOTE: These charts are not meant to represent the actual ETFs you might buy in your portfolio. They are just meant as quick examples of real market fluctuations.

Are You Brave, Patient and Stalwart Enough to be a Couch Potato?

Intestinal fortitude. That’s what you need to be a good Couch Potato index investor.
You have to be prepared to stomach more than a 30% market drop for one, or more, of your ETFs.

If you truly want to be a Couch Potato, you have to be prepared to lounge back through a 50% market drop and keep waiting, often for years, for your holdings to gradually climb back up to where you bought them at.

That means you have to wait to *break even*, not just to make a profit.

If you sell during a drop, you will almost always lose. And you are not a Couch Potato Index investor any more.

Some people who try to be Couch Potatoes panic when the markets drop. They sell low. They won’t wait years for a rebound. They then curse the markets and stalk off to invest only in GICs and savings accounts.

Regular contributions do make drops easier to weather because you buy some new units when prices are low to help offset the ones you bought when prices were high. It makes it feel like you’re making money more quickly as you wait for the re-bound.

Proper annual rebalancing is also critical and as a bonus it can obscure the cause of your paper losses. (Remember they are not TRUE losses unless and until you sell your ETFs.)

Who Does Couch Potato Index Investing Work For?

It could work for anyone, if they let it.

It certainly will work for someone who is totally dispassionate about finances and fully capable of ignoring even catastrophic market crashes because he/she understands and believes the mathematics behind this investment method.

It works for thousands of people.

It might work for you.

Am I a Couch Potato Index Investor?

No.

I won’t let it work for me: I am extremely risk averse. I know I would not be willing to watch 20% of my invested money (in any one index) drop to half its previous value.

We do use Couch Potato Index Investing within one of our defined contribution pension plans. Frankly we have no other logical choice. It’s doing reasonably well but it sure does hurt to wait out the times the markets are down and the agonizingly long time it takes for the markets to rebound. Fortunately, our bonds fund did extremely well during the last market drop which buffered the loss somewhat.

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Are you a Couch Potato Index investor? Or do you actively trade? Or are you a Fixed Income Only investor? Or do you take a hybrid approach? You’re probably doing reasonably well using any method if you have no debts and are steadily saving money. Please share your opinions and advice with a comment.