This article was originally published on May 4, 2016, but is still relevant today.
You worked hard for your money. You’ve also learned that the smart thing to do with money is to invest it instead of putting it under your mattress.
The best way to invest your savings, according to Warren Buffett, is to “put it all in a low-cost index fund that tracks the S&P 500 and get back to work”. If you did that, you would get about 10% annual return and your money would double every eight years.
But this view is oversimplified. In reality, the stock market doesn’t behave. While the S&P 500 index might have gained 10% per year on average, it didn’t do so in a neat exponential curve. In fact, the curve tends to be a wild roller-coaster ride full of erratic increases and sharp drops. All we know is that over the past hundred years or more, the stock market has gone up in general. Based on all the information we currently have, the trend will continue.
If the market behaved
The S&P 500 chart in Google Finance goes all the way back to April 2, 1976. That’s 40 years of data.
Looking at the chart, it looks like the market was nice and stable for 20 years, then it got all crazy with the tech bubble, the housing bubble, and recently perhaps another bubble yet to be named. But looking at the chart this way fails to take into account that the market is supposed to go up exponentially, not linearly. That is, $100 making 10% gains each year is supposed to become $259 in 10 years, not $200. This happens because of compounding.
So let’s take a look at what the chart looks like when we make it logarithmic to take into account the compounding.
From a logarithmic perspective, it doesn’t look so crazy. In fact, it looks as if the market may be undervalued today. Fitted with the trend line, we can see the recessions of the 70’s and early 80’s, the dot-com bubble of the late 90’s, and the financial meltdown around 2008. Based on this trend line, we have not yet fully recovered from the last financial meltdown.
In theory, the markets should always revert back to the mean. Whenever the market strays too far from the trend line, it should correct itself and snap back. So in theory, there is an economic boom on the way.
Of course, nobody can predict the future, and everything depends on the perspective in which you look at it. What if the assumption that the market was behaving normally for most of the past 40 years is incorrect?
The graph above shows a more pessimistic view of the U.S. economy. This graph assumes that the slow growth of the late 70’s and early 80’s was the norm, and the market actually corrected itself back to normal in early 2009. According to this theory, the unprecedented growth during the so-called “tech boom” is over, and we’re heading back to business as usual in the United States. If this view makes more sense to you, then brace yourself for a big 50% stock market drop sometime in the near future.
Personally, I am an optimist who believes that better times are ahead. All my savings are in the stock market. The rationale is that if some calamity strikes the United States in the future and causes a total economic collapse, I will have more important things to worry about than the size of my bank account. In that worst-case scenario, money would probably be worthless anyways.
In his book Antifragile, Nassim Taleb describes the Thanksgiving Turkey Problem. Every single day for its entire life, a Thanksgiving turkey is fed by the farmer. In the turkey’s point of view, the farmer is benevolent. The turkey can expect to be fed by the farmer every day. However, one day just before Thanksgiving, the farmer butchers the turkey. By the turkey’s point of view, this would be totally unexpected.
So yes, the S&P 500 will keep going up, until it doesn’t. Nothing lasts forever. It is smart for us to invest in the S&P 500, but it is also prudent to keep in the back of your mind the possibility that it stops going up as expected.
To survive a total economic collapse, you need to diversify. When you invest in the stock market, your wealth is all in paper and data. If you want to survive an economic collapse, you also need to own physical goods. Even if the stock market collapses all the way to zero (highly unlikely, but remember the happy turkey), you will still have all your physical goods. No amount of stock market turmoil or Internet-crashing can take that away from you.
So yes, the stock market is still a great place to invest your savings. Just make sure you have a “plan B” in case it all hits the fan.