Focus on What You Can Control: Preparing for When Markets Go Down
I recently came across a personal finance Instagram account that looked different from all the others I follow.
There were no motivational Tweets inexplicably shared as Instagram posts.
There were no “10% average return” projections.
There weren’t even the obligatory, “Stop spending all your money on takeout, you fat cow!” posts.
(Can you see why personal finance corners of the internet need a makeover? I digress.)
Often times in an effort to make things simpler and get people excited about investing, we often present half-truths or “This is true, but only with this very important caveat,” statements in pithy, easily shareable ways (because #content, right?).
This account brought up the hard stuff: Inflation risk. Macroeconomic trends. What happens if you take index investing to its logical extreme, wherein everyone becomes a passive index investor, and suddenly the market starts acting crazy because it’s theoretically “price-insensitive.” (Oddly enough, the Atlantic just wrote a piece about this very topic.)
…when I tell you I spent the entire rest of that Saturday laying on the couch, staring at the ceiling, and questioning everything I believe, I’m not exaggerating.
Why this knowledge presented this way sent my assumptions into a tailspin
For starters, I consider myself pretty well-read – I’ve probably churned through 10-12 personal finance books in the last two years, and spent an equal amount of time listening to podcasts, verifying my strategies using sources like NerdWallet and Investopedia, and simply talking to other personal finance nerds.
The idea that some giant, unnoticed macroeconomic trend could blow up my entire plan (or, more specifically, that I’d have to become an economist to understand what to do) utterly freaked me out.
Upon further research, I know it was just the accumulation of all the potential worst case scenarios in one spot that sent me over the edge – that feeling of, “Shit, do I know ANYTHING?” But in reality, a lot of the topics broached were still in my realm of awareness already – they just weren’t the front-and-center focuses of my personal finance knowledge repertoire.
And in full transparency, I, too, get frustrated by some big personal finance accounts who paint half-truths and generalizations as cold, hard facts. The underpinning of that frustration isn’t fair, though, because it assumes that those accounts’ followers aren’t fully competent adults, capable of doing their own research and making decisions for themselves.
How I reasoned my way through some of these big “doom and gloom” personal finance topics
My biggest takeaway was this:
You have to focus on what you can control, because you have very little control over market returns and inflation. You can control for (a) your own tax liability and the tax “drag” on your portfolio, and (b) your diversification.
Of course, the other obvious thing you can control is increasing your save rate. Even if, for some reason, the market has horrifically low returns over the next two decades, you can help offset that pain by keeping your living expenses low (read: reasonable) and saving more of your income.
Because after all, the people who are truly relying on an everlasting 14.7% S&P 500 return (the average annualized rate of return over the last 10 years) are those who may not be saving very aggressively in the first place.
Controlling your tax liability
This is a huge one. And really, there are only a few major (legal) ways to control how much you’re paying in taxes:
Contributing to a pre-tax 401(k) to defer up to $23,000 per year
Contributing to a Roth IRA to get money in an account that’ll never be taxed again, up to $7,000 per year (post-tax money, but amazing tax-free growth potential)
I often get asked what the point is of investing in a Roth IRA instead of just going straight to taxable investing, since your contributions are taxed in your marginal tax bracket for both (theoretically) – the difference over decades can be significant, so it’s definitely worth it to consider maximizing that Roth IRA goodness
Contributing to other pre-tax accounts that are a little less common but great if you can get them
Here’s the thing – you can save thousands of dollars per year, every single year, by leveraging accounts like these. And as they grow, you’re likely to see your savings increase exponentially over time (since the “tax drag” on your investments compounds just like growth does).
Consider this hypothetical:
Hot Girl Heather makes $120,000 per year. She’s probably a corporate big shot or works in medical device sales or has some other, high-paying Hot Girl career.
Heather’s taxable income is $105,400 (after she shaves off her generous standard deduction), which makes her marginal tax rate 24%.
That means – if she maxes out her 401(k) at $23,000 and her HSA at $4,150 per year – she can potentially avoid paying taxes on $27,150 of her income.
The $23,000 is invested, and so is the $4,150 (if you opt to invest within your HSA, which is pretty standard).
By leveraging pre-tax accounts, Hot Girl Heather could offset investment losses (in a down market).
And that’s just by contributing to accounts that she keeps! Remember, you’re really just paying yourself (through some fancy tax footwork) instead of taking all the money as big, dumb cash payouts.
While the tax code could change and they could theoretically eliminate tax-deferred accounts, it’s not likely (in this reporter’s opinion) – and controlling, to some degree, how much you pay in taxes has a direct impact on your bottom line and it’s within your control, unlike what the market does or how inflationary trends go.
Diversifying your investments
A lot of my favorite FI minds claim that VTSAX is the only index fund you need, because it represents the entire stock market.
While that’s true, it’s also one of those things that requires a slight disclaimer: The index fund is cap-weighted.
I posted recently about what “cap weighting” means – but all you need to know for now is, big companies get preference.
An analogy that only gives me slight high school PTSD
Let’s go back in time to your high school. I want you to imagine your graduating class.
Now, imagine the five most popular kids you knew. Everyone thought they were cool. If your high school graduating class was a stock market, they’d be the hot stocks everyone was investing in (read: talking about, worshipping, and betting on).
Now let’s pretend someone made an index fund that represented an interest in every single kid in your high school graduating class. The jocks, the nerds, the art kids, the popular girls – everyone is represented.
As if the NASDAQ looked like this.
“Cap-weighting” means the popular kids get preference.
So if your popular girls were Brittany, Britney, Britneigh, and Britnay, the four B’s would make up about 20% of the entire fund’s value.
That’s right! Four girls make up almost a quarter of the index fund that represents your high school graduating class. The rest of you (maybe you graduated with, say, 2,000 kids) would make up the other 80%, in decreasing order of popularity.
Now, JL Collins would probably say that’s a good thing
He’d say, “Well, that means you’re only getting the winners! It’s self-cleansing.”
Eh, kind of.
There have been periods of time (in… the lunchroom) where the popular kids didn’t do so well.
It’d be like if Regina George’s “sweatpants are the only thing that fits me right now” phase lasted from 2000 to 2009, and during that time, Cady Heron had her massive come-up. She’s a small cap value fund – unexpected (from Africa, no less) and ready to take over the index using nothing but a tank top and three candy canes.
Making sure you’re diversifying properly is a really great way to help protect yourself from periods where the popular kids go bunk.
This is a really dense and involved investing topic that’s – candidly – out of my depth, but one thing to know is that using a roboadvisor can help diversify your funds within the stock market for you.
Now, you could make a case for things like cryptocurrency, gold, or other assets that are outside of “the stock market” (like investing in a drummer who goes to a public school in a different zip code – total wild card), but again, I’m not here to make investment recommendations – just to tell you that diversification beyond the “two funds for life” method (VTSAX or its equivalent and a total bond fund) may make things more complicated, but it’ll also (likely) offer some protection from “down markets” because it scatters your eggs in more baskets.
Conclusions
By investing in your 401(k) (or equivalent employer-sponsored account) and a Roth IRA first, you can avoid a tax drag. The fact of the matter is, there’s very little you actually have control over (in investing, and life in general).
Sometimes, the realization and acknowledgment that you aren’t in control is oddly comforting – because beyond things like tax management and diversification, there’s not a lot you can do – even if you’re willing to work hard!
But the stock market is still a great tool we have to (passively, near-effortlessly) build wealth, and while we may not always see returns in the double digits for multiple years in a row, I have to think something that represents our very capitalist engine (and all the work of the people inside it) is destined to – over the decades – come out ahead. It has, at least, for the last century.
Of course, the last thing you should prep for is this: The inevitable drop will come. You have to psychologically prepare yourself. We all do. When things start to go down (before they generally go back up, eventually), you have to find the steely resolve that you won’t flinch and sell.
And usually, that’s the hardest part.
