As I’m writing this in October 2022, the S&P 500 — which tracks the top 500 companies in the United States — was at its lowest since March 2020.
Meanwhile, the global inflation rate is at a level we haven’t seen in 40 to 50 years. On top of that, we have a list of other global challenges, ranging from climate issues to war. It’s not looking good.
To people without experience with investing in the stock market, it seems extremely risky to start investing when prices are low.
The assumption is that stocks are down for a reason. On the surface, that seems true. When there’s unrest in the global economy, stocks are generally lower, which is actually a positive thing for long-term investors.
But it’s perceived as bad. They assume that investing is somehow more dangerous when prices are low. But the relationship between risk and reward is not a complicated topic at all.
Put simply: When perceived risk is high, expected returns are high because real risk is likely low.
Let’s break that down.
Real risk vs perceived risk
Risk is the possibility of losing money. But there’s a difference between perceived and real risk.
- Real risk = The qauantifiable possibilities of loss.
- Perceived risk = The expected possibility of loss based on judgment.
Real risk is a highly complex field. This is something we leave up to the mathematicians and statisticians of the world. But every person constantly makes judgments about the economy and the world.
The problem with perceived risk is that it’s subjected to our emotions. And that’s exactly why investing is so hard.
Our perception is that risk is high when the stock market is in turmoil. But as the financial writer William J. Bernstein explained in his book, The Four Pillars of Investing, this is not true:
“High previous returns usually indicate low future returns, and low past returns usually mean high future returns.”
This is one of the biggest paradoxes of investing. Amateurs perceive risk as low when the world is stable and prices go up. The professionals know risk is low when everything collapses. This is why stock markets usually bottom when sentiment and news is at its worse.
Think of the stock market bottom of the Covid crash in April 2020. It was the absolute low point of the crisis. It was when professional sports was shut down and even Disney closed their parks. Everyone was sitting at home, confused.
That’s when the market bottomed.
In contrast, when stocks are at all-time highs, it’s only safe to assume that stocks won’t go up forever. We live in a capitalistic society, which means we’re always subjected to boom and bust cycles. It’s part of the game we play, and there’s nothing wrong with that.
The key is to pay a lower price for it today.
Low price = lower risk
When I tell new investors that the perfect time to start investing is when the market is down, they always frown.
“What if the market keeps going down?”
Well, as long as you’re using a sound investing strategy like buying an S&P500 index fund, you can safely say that the possibility of losing all your money is low. That will likely happen when society collapses. At that point, money also collapses.
The truth is that the possibility of losing money is highest when you buy risky assets at high prices. Look at all the people who bought Bitcoin or individual stocks during 2021, when all asset prices were at all-time highs.
With this knowledge, you could look at the market and say, “It’s risky to buy because prices are high.”
This is such a difficult concept to execute that the most sophisticated economists and investors fall for assuming low prices mean high risk. The opposite is true for high-quality assets.
Now, when I talk about investing, I only talk about investing in quality companies. I.e. the S&P500 index. This whole article doesn’t apply to risky assets because they often have no realized returns.
A new public company can easily go bust. Then, you’ve lost all your money. That’s why I’m strongly against picking stocks when you start investing.
For passive investors, low prices are golden times. When the S&P500 index is down 20% or more, I feel even better pouring my money into the market than when everything has been going up for a long time.
So, when’s the perfect time to start investing in the stock market for the long run?
When prices are low.