How to Think About Market Drops

3 min read

The whole point of investing money now is to have more money later. And what you invest in is dependent on when you’ll need the money.

As a rule of thumb:

Stocks are high-growth and have high volatility.

Bonds are low-growth and have low volatility.

This means that if you invest now in stocks, your investment will probably take a bumpy, high-growth ride to higher prices.

Conversely, if you invest now in bonds, your investment will probably take a smooth, low-growth ride to higher prices.

The amount you invest in stocks compared to bonds is known as your asset allocation. And this allocation should be determined by when you need to sell your assets and cash out.

If you’re young and you’re in the prime of your working years, you can rely on income that you earn from working to fund your lifestyle. This income can be used to buy Chipotle burritos and pay your electricity bill each month.

If you’re old and you no longer want to work to earn an income, you will be more dependent on selling your investments in exchange for cash to have the means to pay for your burritos and your electricity.

This is why it’s a good idea for young people to invest mostly in stocks. You don’t need the money now since you have a working income to fund your lifestyle. In 15-30 years when you do need the money, your investments will likely be worth a lot more. The path that your stocks take to a higher price may be volatile, but that doesn’t matter because you’re not interested in selling and cashing out along the way anyway.

By contrast, it’s a good idea for older people to allocate more of their investments to bonds. If you don’t have a working income, you need to occasionally sell some of your investments to fund your lifestyle. And since bonds are low-volatile, you can be confident that you’ll be able to sell your bonds in exchange for cash without fear that the prices will drop unexpectedly.

How to Think About Market Drops

The stock market dropped about 7% this past week:

How should you think about this recent drop?

Well, that depends on if you’re interested in selling stocks to fund your lifestyle. If you’re someone who doesn’t plan on selling your stocks for several decades, you shouldn’t flinch. In fact, a market drop is an opportunity to pick up more shares at cheaper prices. After all, you shouldn’t care about how much you can get if you sell now. You should care about how much you can get several decades from now when you actually need to sell.  

And if you’re someone who needs to sell your stocks in the next few years to fund your lifestyle, hopefully your asset allocation isn’t heavily tilted towards stocks. It’s nearly impossible to predict where the stock market will be 1, 2, or 5 years from now. If you need to sell your stocks to fund your lifestyle within the next 5 years, be sure that your asset allocation reflects this.

Advice for Young Investors

Suppose the price of one share of a stock index fund is $100. Also suppose that I could predict with 100% accuracy that the price will be $200 in 15 years from now. Of course you would invest.

And if the price dropped to $80 tomorrow, you wouldn’t panic. In fact, you’d be elated because you could buy another share for an even cheaper price. And if it dropped to $70 the next day, you’d be even more excited and buy more.

Unfortunately, even though stock prices likely will be higher in 15 years, most people still prefer to see prices go higher, not lower in the short term. It’s fun to see the numbers in your account increase on your computer screen. But if you don’t need the money anytime soon, you should actually hope that prices go lower so you can buy more shares at cheaper prices. 

As a young investor, it’s important to maintain a long-term investment perspective. Short-term price fluctuations are largely irrelevant since you shouldn’t be interested in cashing out anytime soon anyway.

So, invest early, invest often, and recognize that market drops are simply opportunities to invest at cheaper prices.

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Zach

Zach is the author behind Four Pillar Freedom, a blog that teaches you how to build wealth and gain freedom in life.

He quit his day job as a data scientist in 2019 because he was able to earn enough income from profitable websites to replace his salary. He now teaches people how to start and grow their own profitable websites from scratch in the Income Community.

Zach's favorite free financial tool he's been using since 2015 to manage his net worth is Personal Capital. Each month he uses their free Investment Checkup tool and Retirement Planner to track his investments and ensure that he's on the fast track to financial freedom.

His favorite investment platform is M1 Finance, a site that allows him to build a custom portfolio of stocks for free, has no trading or maintenance fees, and even allows him to set up automated target-allocated investments.

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