By Kyu Kim & Richard Sequeira
It was my mom who first told me that every decade or so, there has always been an epic market crash. A lot of experts agree with her that market crashes should never be a surprise (Kaplan). There was the 2000 dot-com bubble, the 2008 financial crisis, and again in 2020 with the Covid pandemic; I felt that the market crash driven by Covid was just another of those phenomena. I knew in my heart that it would go up, but my philosophy then was only to invest the amount I wouldn’t mind losing.
So, as a newbie, in March 2020, I bought ~$15,000 worth of reasonably conservative index funds. I didn’t add or subtract from that account and forgot about it. Although I do wish I had checked every month what was the monthly increase to give you a more detailed account of what happened. Then in Feb 2021, when I checked my account, the balance was over $21000. That’s over 40% return in a year.
Don’t panic when the market panics
I’ve always heard “buy low and sell high.” I’ve heard that the worst mistake is to do the opposite, to “buy high and sell low.” This sounds logical and elemental; after all, one must be invested in the stock market to make a profit. However, I’ve also heard that a lot of people make this mistake. Especially when the market crashes, the inevitable emotional turbulence can cloud one’s judgment.
When the stock market crashes, fear and uncertainty can drive investors to cash out before losing even more. However, it is important to note that stock market crashes are not always an accurate reflection of the health of the market. I am not talking about legitimate drops of an individual stock due to the idiosyncratic circumstances of the company, but cyclical downturns that affect the market in its entirety.
What happened? Market recovery – Covid to the end of 2020
The start of the market recovery can be traced back to the Federal Reserve, the Treasury Department, and Congress taking quick and decisive action to support the economy during the direst part of the meltdown. Congress approved supplemental unemployment benefits and $1,200 stimulus checks, which were quickly sent out by the U.S. Treasury. The Fed cut interest rates to near zero and pushed out a $2.3 trillion package of lending programs to prop up households, employers, financial markets, and local governments.
These actions showed that the US government and the Fed were not going to just let the market crash, which reassured investors and financial markets (Zarroli). What followed by a fluke of history is that the companies that were best positioned to deal with the new realities of the pandemic happened to already be the largest weighted components of many major stock indices -think Facebook, Amazon, Microsoft, Apple, and Google (The Indicator from Planet Money).
Online savings to the Index fund
I’ve always been adamant about dividing my extra cash and storing it into high-interest online savings accounts for different purposes. For example, I have one for a real estate down payment, one for a 6-month emergency fund, one for the rest of my tuition, and so on. This way, I can ensure that my large expenses are covered and I am not tempted to spend them on less important things. Then I can spend freely what I have from my salary this year after setting aside a portion for retirement savings and donations.
But that was when I was younger and satisfied with the 2.7% interest rate from the online savings account and Certificate of Deposits, which fell to under 0.4% due to Covid. As you know, the Federal Reserve lowered the interest rate so banks had to follow suit to stay profitable. The highest online savings account on the market is now around 0.6%. I used to like online savings accounts and Certificates of Deposit because they offer higher interest than regular checking or savings accounts but are still insured for 250,000 if it is an FDIC insured account. However, my reasonably calculated risk during Covid convinced me that I am ready to take on more of it for a much higher return.
Now, I am thinking about investing some of those funds that are sitting in my various savings accounts into index funds that I tried out during Covid. Most of my current savings accounts are prepared to be used in over a year or more. Even if I do end up cashing out the investment within a year, the higher interest rate will still justify the capital gain tax.
What is an index fund and which one am I considering buying?
An index fund is the antithesis of picking individual high-performance stocks. They are already diversified for us, meaning that the fall of individual stock will not detrimentally affect the fund too much. Therefore, it becomes much less of a gamble than picking one hot stock that could potentially do well in the future.
An index fund is a type of mutual fund with a portfolio made up of stocks of a financial market index. An index mutual fund such as the Standard & Poor’s 500 Index or the Total Stock Market Index provides broad market exposure, low operating expenses, and low portfolio turnover. An S&P 500 index fund, which consists of 500 large-cap stocks in the S&P 500, is a safe investment, but a Total Stock Market Index fund provides slightly more diversification, since it includes between 3,000 and 5,000 small-, mid-, and large-cap U.S. stocks. These are two popular index funds and people have different opinions about them, but in the end, both types of index funds are heavily weighted toward large-cap stock and their performance is highly correlated (Thune).
I decided to park ~$150,000, about ten times more than what I did last year, in a Total Stock Market Index fund this February since I don’t need it for more than a year and it’s a good amount to test this out. I will write about it next year. Since the inception of the fund in late 90s, it has had an average annual return of 8%+ and most interestingly a return of 20%+ during the past year. Of course, it was a much higher return than usual due to the Covid outbreak. Therefore I don’t expect a 20%+ return next year, but I would suspect it would be still much higher than my online savings account.
Other things to consider
Should you wait to invest until the next crash? In my case, it was the crash that enabled me to get out of my comfort zone of online saving. However, the ones who just invest in the market rather than sit on cash waiting for the next crash tend to have better returns on average (Lee). Therefore, instead of waiting another decade, I am investing my funds now.
As I mentioned above, selling stocks incurs capital gain tax. This encourages people to invest for the long-term, resulting in a more stable stock market for everyone. If you buy a stock and sell it within a year, you could be taxed up to 37% on your profit. On the other hand, if you hold on to them for longer than 1 year, the tax rate is reduced significantly. This is called long-term capital gains tax. As we learned from our accounting class, we can change from the average cost method to the first-in and first-out (FIFO) on your brokerage account to check the balance of stocks that are older than a year to reduce capital gains tax.
Source & Disclaimer
The Indicator from Planet Money. “Stocks Are Up But The Economy’s Down.” NPR, https://www.npr.org/transcripts/861331371. Accessed 2021.
Lee, Samuel. “Waiting for the Market to Crash is a Terrible Strategy” SVRN Asset Management, https://svrn.co/blog/2017/5/14/waiting-for-the-market-to-crash-is-a-terrible-strategy. Accessed 2021.
Kaplan, Paul D. “What Prior Market Crashes Can Teach Us About Navigating the Current One.” Morningstar, https://www.morningstar.com/features/what-prior-market-crashes-can-teach-us-in-2020. Accessed 2021.
Thune, Kent. “Total Stock Market Index vs. S&P 500 Index” The Balance, https://www.thebalance.com/total-stock-market-vs-sandp-500-2466403#:~:text=The%20primary%20difference%20between%20a,both%20represent%20only%20U.S.%20stocks. Accessed 2021.
Zarroli, Jim. “Stocks 2020: A Stunning Crash, Then A Record-Setting Boom Created Centibillionaires.” NPR,https://www.npr.org/2020/12/31/952267894/stocks-2020-a-stunning-crash-then-a-record-setting-boom-created-centibillionaire. Accessed 2021.
Past results are not a guarantee of future performance. The information provided here is written by a student, not a financial professional, for general conceptual informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be accurate or suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.