The official blog of BNP Paribas Asset Management

Finance: Why worrying about stock market crashes can be costly

stock market crash

If you spotted a dollar bill or a euro coin on the street, would you pick it up? Most people would say ‘yes’ and that is why economists argue there is no money to be found on the street. Judging by their behaviour, many, not to say most, investors would refuse to pick it up, as if they’re worried a car will hit them when they bend over. In market terms: they’re worried about market crashes (rather than car crashes…). Why is this and what are the financial implications of this attitude?

Most investors are risk-averse: they are more sensitive about losing money (even if the loss is unrealised, i.e. they haven’t sold the loss-making position yet) than about missing out on a nice opportunity. Possible explanations are that the volatility of their investments makes them feel sick: they compare how much they earn per month with the swings of their investment portfolio (the so-called value at risk – how much you can lose in rather extreme, though not unrealistic, circumstances). For many people, their monthly salary could be lost by a market downturn in just one week. Looking at the value at risk of their portfolio in euro or dollar terms scares many people off. Another explanation is that investors over-estimate the risk of big market corrections (crashes). The further equity markets have risen, the more pervasive this behaviour becomes. Although psychologically understandable, in economic terms this behaviour does not make sense. It is what finance people call inefficient: the realised return in the long run will be lower than what you could have realised if your portfolio had been optimally aligned with your investment horizon. For example, if you plan to retire in 20 years’ time, your horizon is long enough to take more risk by being quite significantly invested in equities, which in the long run tend to offer higher returns. (I say ‘tend’ because there have been cases where over a 20-year period equities did less well than bonds, but these have been exceptional). Moreover, it’s an argument for having an internationally well-diversified equity portfolio: some financial markets may do poorly over a long period, but it is very unlikely that all of them would do so. Yet many people do not buy into this argument for the reasons mentioned above (focus on value at risk; crash worries) or because they have doubts about the long-term expected return estimates for equities or other asset classes that can give a higher return than government bonds (e. g. corporate bonds, high-yield bonds, emerging debt, etc). They may also think (indeed be under the illusion that) they’ll make up the lost ground later on. I’m using ‘lost ground’ on purpose here. Short-term interest rates are now very low and will continue to be so for a while yet. For many people, accumulating wealth at such a slow pace will make it difficult for them to make ends meet once they retire: taking into account how much they can save annually, the required long-term return is higher than the current low level of interest rates. Even if an investor buys long-dated government bonds, he would still not achieve his target. In financial terms, this investor is running a ‘negative carry’ position: the realised return on his very defensive strategy is lower than the return he needs to achieve in the long run. To bridge this gap, without counting too much on expected capital gains, which for many people is a bit of ‘pie in the sky’, an investment strategy focused on high income (via dividends, coupons on corporate bonds and emerging debt – I want to insist on the necessity of diversification) can be attractive. It boosts financial income today, which implies that net savings are higher than in the case of a ‘no risk’ investment strategy. Let me illustrate this with the following ‘back of the envelope’ calculations. A person has an annual wage or salary of 24 000 euros or dollars. He spends EUR/USD 18 000. He has a financial portfolio of EUR/USD 100 000. The interest rate on safe assets is 1%. The income (from dividends and coupons) on a well-diversified portfolio is 3%. The expected capital gain is 2% per year. The investment horizon is 20 years. There is no inflation. Putting all the money in safe assets implies an immediate opportunity cost of 2% per year, so 2 000 euros or dollars on the initial portfolio in comparison with the riskier strategy. This also means that annual savings are lower and that the accumulation of wealth is slower: you save less than you could and you invest at a lower expected return and with a lower yield (annual income/financial wealth). Even without taking capital gains into account, the difference over time is sizeable. After five years, it is 8.6% and by 2026 it is 20%. To put it simply: the investor who puts all his money in very safe assets generating a very low income, while having a long horizon, implicitly says: 1.   That the interest rate on Treasury bills and bank deposits will rise significantly in the not too distant future 2.   That equity markets will stay flat over a long period and that at some point between now and 2026 they will crash by 20%, and not recover thereafter. It’s up to the reader to assess how realistic these assumptions are. For me, the answer is clear.

Related articles

Weekly insights, straight to your inbox

A round-up of this week's key economic and market trends, and insights on what to expect going forward.

Please enter a valid email
Please check the boxes below to subscribe