Lessons from Watching My Investments Drop in Half

by Adam on May 19, 2010

stock market can be like a yoyoThe Stock market can be a strange thing:

It can shoot up.

It can collapse.

And the Yo-Yo movement can make it seem to be acting completely crazy sometimes.

But when you have the right mindset and stick with a well thought-out plan it can be a tremendous wealth builder over the long term, growing your pennies into a stockpile for a future time, like collecting wood for winter.

One of the great things about a blog on personal finance is the chance to share a personal perspective on money-matters so I thought it worthwhile to share a real example of how understanding risk helped me grow my pennies in one of the craziest periods the market has ever seen.

I hope that by sharing this example you will have a better understanding of investment risk.

A Real-Life Example: Watching my investments drop in half.

I set out to grow my pennies initially by concentrating on simple index funds. I knew there were a million and one ways to invest in the stock market but sticking with an index fund (an investment than includes every stock in a ‘index’ like the FTSE in my case) would be a good start (more on this in future posts)

Of course, knowing I had such a long time horizon I began getting more curious about investments further away from home: particularly the mythical ‘emerging markets’ –investing in countries with economies that are set to grow in the future: like Brazil, Russia, India, and China (known as the BRIC economies).

After doing a bit of reading I decided to buy some units in a fund that focused on buying shares in companies in South America, primarily Brazil.

This was the beginning of 2008 before the full extent of the credit crunch was known so I had a huge surprise when, only days after making my initial investment, my investment valuations went into freefall!

Myth: Diversification avoids all investment risk.

Investing in a fund containing lots of different stocks and shares is much less risky than investing in only a few single shares, but it is still risky because stocks and shares in whole industries and countries can go down together.

You therefore need to make sure that before you make any investment that you think not only about diversification (how deep you go into stocks in terms of the range of investments) but also about asset allocation (how you spread your pennies across a range of assets –like cash, stocks, and bonds).

Asset Allocation is Important: For 20 and 30s somethings it means: Have you enough cash?

Thankfully I had  already made sure my asset allocation was set –I had plenty of cash savings which helped me  not to panic when my ‘emerging markets’ investment almost halved in a matter of months.

By the end of 2008 my my investment was down 50% (rather than the Year end figure of -40% above because I had invested almost right at the top, part-way through the year).

Those of us in our 20s and 30s can be much more ‘risky’ with our investments if we are investing money we won’t need for a long time –we can therefore give our money a chance to grow over the long term (with the possibility of significantly higher growth rates compared with a  savings account).

Ultimately having a long term view and a good asset allocation has helped my investments to do well so far – as you can see I decided to buy even more shares at a lower price so as of now, my ‘emerging market’s investment has done very well for me.

Remember though, this could have been disastrous if I had needed to sell during 2008. In fact for many older people, the craziness of the stock market in 2008 was indeed disastrous to their life savings.

Lessons To Remember

My experiences in this investment also taught me an important lesson about asset allocation and greed.

  • When you begin building momentum with your savings it can be tempting to invest as much as possible. However if I had been greedy and put all my money into investments at start of 2008 I would not have been able to invest much more money after the slump, nor would I have been able to touch that money in the event of an emergency without losing a huge amount.
  • Being young certainly means we can take on more ‘risk’ but you have to be disciplined and rational about your long term plan if you want to be successful with your investing. Asset Allocation is just as important as diversification i.e. –prepare to spread your money around investments but keep cash on hand too!

It’s worth it though: from a long term perspective, as companies create value every day, stock market indices have always performed like someone playing with a yo-yo whilst walking up the stairs:

Up and down, up and down, but over time, you end up much higher than where you began.

Are you ready to begin the climb?

{ 4 comments… read them below or add one }

Balance Junkie

Diversification as a risk sterilizer certainly has become a myth, especially over the past decade as markets have become more and more correlated. I agree with your advice to keep a healthy cash stash. The markets are particularly unstable right now, so extra caution is warranted.

Sam

the wonders of hindsight. i bet someone made a killing investing at the bottom of the slump, just watching the market pick up again.

personal question: being young and risky (that sounds a bit wrong…) if you hadnt of invested at the time you did, but you knew emerging ecomonies can be potentially profitable, if you’d seen that sudden drop in the market, would you have had the balls to invest? not knowing it was about to go up, just based on your theory and background reading? i know thats investment banking territory but just wondered.

Adam

Thanks 2 Cents. You’re right, cash is important -I guess the main challenge is finding the right balance. You should be investing not keeping all your money in cash, but not investing so much that you would be in trouble if something goes wrong!

Sam -as the graph shows, I did reinvest quite near the bottom so made quite a good return (not that I ‘realised’ that gain and over the long term it doesn’t mean much). This is only one example I also increased my other investing throughout the credit crunch because I knew over the long term this was the buying opportunity of my generation. 🙂

Len Penzo

I’ve been keeping a large stash of cash on the sidelines since early 2008 and I have it used it to jump in and out of investing opportunities since then. Then again, in one particular instance I jumped into an opportunity that resulted in a hefty loss too (darn it!). So, even this strategy can have its problems at times if you pick the wrong investment! 🙂

All the best,

Len
Len Penzo dot Com

Previous post:

Next post: