Investment crash benefits youthful investors: an explanation of the theory.
In a fascinating perspective, renowned investment expert William Bernstein suggests that stock market crashes can be advantageous for young investors. This is because a crash provides an opportunity to purchase stocks at significantly lower prices, which can lead to greater long-term gains due to the power of compounding returns over time.
The key condition for this advantage is primarily the investor's patience and ability to remain fully invested despite market volatility. Young investors, who do not usually require immediate liquidity, can withstand the losses during a crash and benefit from eventual market recovery and compounded growth of their investments.
This viewpoint aligns with Bernstein's broader advice on risk and diversification, emphasizing that although stocks are volatile, their long-term returns tend to outperform other assets for investors who can afford to stay invested through downturns.
Let's consider Hanna, an investor who invests 1,000 euros per year, with annual increases of 4.0%, reaching 1,040 euros in the second year, based on the assumption of a 4.0% annual increase in income over 35 years. During this 35-year period, an investment in the global stock market generates an annual return of 8.0%.
The calculations, which do not consider costs and taxes, are based on an investment period of 35 years, which is approximately an investor's life or generation. The latest year in which a full recovery can still occur within the definition of four years is Year 31.
A hypothetical investor, Hanna, is assumed to experience one severe stock market crash of -60% in a single year during these 35 years. The crash exploitation advantage exists for older investors as well, not just those under 30 years old.
The internal rate of return of all contributions and the final wealth value varies in each scenario due to the timing of the crash. The total contributions over the 35-year period amount to just under 74,000 euros.
Interestingly, the calculations show that in all four crash scenarios, the final wealth and the average return over the 35-year period are higher than in the reference scenario without a crash. For instance, in Scenario 1, the internal rate of return is 10.2%, while in Scenario 4, it is 9.3%. The reference scenario has an internal rate of return of 7.8%.
If one looks at the ten worst global stock market crashes in the past 120 years, four years would approximately correspond to the average duration of the recovery phase. A slower recovery phase would have an impact on the results. However, if the 60% crash is distributed over two or three years, it would not essentially change the results shown above.
In conclusion, William Bernstein's statement, "If you are in your twenties and just starting to save, then get down on your knees and pray for a stock market crash," holds true under realistic conditions for investors who are already invested. This perspective underscores the importance of patience, long-term thinking, and staying invested during market downturns for young investors seeking to maximize their long-term returns.
[Table 1: Illustration of the impact of the timing of a single 60 percent crash at different points within a 35-year period, with a subsequent four-year recovery phase and a reference scenario without a crash.]
Young investors, like Hanna, can leverage stock market crashes to their advantage by continuing to invest and remaining patient during market volatility, as suggested by investment expert William Bernstein. With their personal-finance strategy of systematic investing and long-term thinkings, they can reap higher returns over time by exploiting the lower prices that come with crashes and capitalizing on the compounding returns of their investments.
