Stock Investing For Dummies
Book image
Explore Book Buy On Amazon
Although the stock market can help you build wealth, most people recognize that it can also drop substantially—by 10, 20, or 30 percent (or more) in a relatively short period of time. That’s an example of market-value risk — that is, the risk that the value of an investment can decline.

After hitting a new all-time high in February 2020, the U.S. stock market got clobbered by COVID-19–related concerns and containment measures that impeded people’s travel and other activities and ended up leading to a sharp, short-term recession. In a little over one month, from peak to bottom, the Dow Jones Industrial Average plunged 36 percent.

After peaking in 2000, U.S. stocks, as measured by the large-company S&P 500 index, dropped about 50 percent by 2002. Stocks on the NASDAQ, which is heavily weighted toward technology stocks, plunged more than 76 percent from 2000 through 2002!

After a multiyear rebound, stocks peaked in 2007 and then dropped sharply during the “financial crisis” of 2008. From peak to bottom, U.S. and global stocks dropped by 50-plus percent.

In a mere six weeks (from mid-July 1998 to early September 1998), large-company U.S. stocks fell about 20 percent. An index of smaller-company U.S. stocks dropped 33 percent over a slightly longer period of two and a half months.

If you think that the U.S. stock market crash that occurred in the fall of 1987 was a big one (the market plunged 36 percent in a matter of weeks), take a look at the following table, which lists major declines over the past 100-plus years that were all as bad as or worse than the 1987 crash.

Largest U.S. Stock Market Declines*

Period Size of Fall
1929–1932 89% (ouch!)
2007–2009 55%
1937–1942 52%
1906–1907 49%
1890–1896 47%
1919–1921 47%
1901–1903 46%
1973–1974 45%
1916–1917 40%
2000–2002 39%
2020 36%
* As measured by changes in the Dow Jones Industrial Average

Real estate exhibits similar unruly, annoying tendencies. Although real estate (like stocks) has been a terrific long-term investment, various real estate markets get clobbered from time to time.

U.S. housing prices took a 25 percent tumble from the late 1920s to the mid-1930s. When the oil industry collapsed in the southern United States in the early 1980s, real estate prices took a beating in that area. Later in the 1980s and early 1990s, the northeastern United States became mired in a severe recession, and real estate prices fell by 20-plus percent in many areas. After peaking near 1990, many of the West Coast housing markets, especially those in California, experienced falling prices — dropping 20 percent or more in most areas by the mid-1990s. The Japanese real estate market crash also began around the time of the California market fall. Property prices in Japan collapsed more than 60 percent.

Declining U.S. housing prices in the mid- to late 2000s garnered unprecedented attention. Some folks and pundits acted like it was the worst housing market ever. Foreclosures increased in part because of buyers who financed their home purchases with risky mortgages. Note that housing market conditions vary by area. For example, some portions of the Pacific Northwest and South actually appreciated during the mid- to late 2000s, while other markets experienced substantial declines.

After reading this section, you may want to keep all of your money in the bank — after all, you know you won’t lose your money, and you won’t have to be a nonstop worrier. Since the FDIC came into existence in 1933, no one has lost 20, 40, 60, or 80 percent of his bank-held savings vehicle within a few years (major losses prior to then did happen, though). But just letting your money sit around would be a mistake.

If you pass up the stock and real estate markets simply because of the potential market-value risk, you miss out on a historic, time-tested method of building substantial wealth. Instead of seeing declines and market corrections as horrible things, view them as potential opportunities or “sales.” Try not to give in to the human emotions that often scare people away from buying something that others seem to be shunning.

Here are some simple things you can do to lower your investing risk and help prevent your portfolio from suffering a huge fall.

Diversify for a smoother ride

If you worry about the health of the U.S. economy, the government, and the dollar, you can reduce your investment risk by investing overseas. Most large U.S. companies do business overseas, so when you invest in larger U.S. company stocks, you get some international investment exposure. You can also invest in international company stocks, ideally via mutual funds and exchange-traded funds.

Of course, investing overseas can’t totally protect you in the event of a global economic catastrophe. If you worry about the risk of such a calamity, you should probably also worry about a huge meteor crashing into Earth. Maybe there’s a way to colonize outer space. . . .

Diversifying your investments can involve more than just your stock portfolio. You can also hold some real estate investments to diversify your investment portfolio. Many real estate markets actually appreciated in the early 2000s while the U.S. stock market was in the doghouse. Conversely, when U.S. real estate entered a multiyear slump in the mid-2000s, stocks performed well during that period. In the late 2000s, stock prices fell sharply while real estate prices in most areas declined, but then stocks came roaring back.

Consider your time horizon

Investors who worry that the stock market may take a dive and take their money down with it need to consider the length of time that they plan to invest. In a one-year period in the stock and bond markets, a wide range of outcomes can occur (as shown). History shows that you lose money about once in every three years that you invest in the stock and bond markets. However, stock market investors have made money (sometimes substantial amounts) approximately two-thirds of the time over a one-year period. (Bond investors made money about two-thirds of the time, too, although they made a good deal less on average.)

odds of making money from stocks What are the odds of making or losing money in the U.S. markets? In a single year, you win far more often (and bigger) with stocks than with bonds.

Although the stock market is more volatile than the bond market in the short term, stock market investors have earned far better long-term returns than bond investors have. Why? Because stock investors bear risks that bond investors don’t bear, and they can reasonably expect to be compensated for those risks. Remember, however, that bonds generally outperform a boring old bank account.

History has shown that the risk of a stock or bond market fall becomes less of a concern the longer that you plan to invest. The figure below shows that as the holding period for owning stocks increases from 1 year to 3 years to 5 years to 10 years and then to 20 years, there’s a greater likelihood of seeing stocks increase in value. In fact, over any 20-year time span, the U.S. stock market, as measured by the S&P 500 index of larger company stocks, has never lost money, even after you subtract the effects of inflation.

hold stocks longer to make money The longer you hold stocks, the more likely you are to make money.

Most stock market investors I know are concerned about the risk of losing money. The figure clearly shows that the key to minimizing the probability that you’ll lose money in stocks is to hold them for the longer term. Don’t invest in stocks unless you plan to hold them for at least five years — and preferably a decade or longer.

Pare down holdings in bloated markets

Perhaps you’ve heard the expression “buy low, sell high.” Although I don’t believe that you can time the markets (that is, predict the most profitable time to buy and sell), spotting a greatly overpriced or underpriced market isn’t too difficult. You should avoid overpriced investments for two important reasons:
  • If and when these overpriced investments fall, they usually fall farther and faster than more fairly priced investments.
  • You should be able to find other investments that offer higher potential returns.

Ideally, you want to avoid having a lot of your money in markets that appear overpriced. Practically speaking, avoiding overpriced markets doesn’t mean that you should try to sell all your holdings in such markets with the vain hope of buying them back at a much lower price. However, you may benefit from the following strategies:

  • Invest new money elsewhere. Focus your investment of new money somewhere other than the overpriced market; put it into investments that offer you better values. As a result, without selling any of your seemingly expensive investments, you make them a smaller portion of your total holdings. If you hold investments outside of tax-sheltered retirement accounts, focusing your money elsewhere also allows you to avoid incurring taxes from selling appreciated investments.
  • If you have to sell, sell the expensive stuff. If you need to raise money to live on, such as for retirement or for a major purchase, sell the pricier holdings. As long as the taxes aren’t too troublesome, it’s better to sell high and lock in your profits.

About This Article

This article is from the book:

About the book author:

Paul Mladjenovic is a renowned certified financial planner and investing consultant. He has authored six editions of the bestselling Stock Investing For Dummies and is frequently interviewed by media outlets including MarketWatch, Kitco, OANN, and more.

This article can be found in the category: