When Should You Not be in the Stock Market?

The answer, of course, depends on whom you ask. Here’s our argument: You should not be in the stock market whenever you may have to sell your entire investment.

Note that the question is not “Is this a good time to be in the stock market?” If you understand the distinction between the two questions, you are well on your way to becoming a successful and sophisticated investor.

Let’s elaborate. Suppose that you’re 30 years old and saving money to buy your first house. The more money you accumulate towards a down payment, the more attractive the home you can afford. You look over your savings and investment opportunities and discover that stocks have historically outperformed bank savings and bonds by a wide margin. You read that stocks generate more money for investors because of something called ‘The Equity Risk Premium’ [more on this in a follow on essay: “What is the Equity Risk Premium”]. This is a no-brainer – stocks it is. Just before you announce your decision to your spouse, you note an item on the internet with the headline: “Noted Expert Explains Why Young Investors Should Own Stocks and Retirees Should Own Bonds.” Great! Now you’ll have some ammunition to justify your decision.

Nevertheless, you remain concerned about risk. You want to protect yourself against an unfortunate drop in your home down-payment account by owning only good, safe, “blue-chip” securities. You really want to protect yourself against the dreadful prospect of telling your spouse that you lost a chunk of the down-payment fund – indeed, you would rather eat a large plate of worms than face such a prospect. No worries, however, because you put your fund in the stock of Fortune Magazine’s “The Most Innovative Company in America” and a member of its “Most Admired Companies in America” for six consecutive years. What could possibly go wrong with Enron?

The above fact pattern brings home the point that a young investor can mismatch the requirements of the investment – i.e., build a down payment in an account that will have to be entirely liquidated at a single moment in time – with the nature of the investment – i.e., a fund steeped in stock risk. The investor should not have been in the stock market because it was not appropriate to the family’s needs, purposes and goals.

A few observations:

  • The analysis presented above has nothing to do with whether it is a good time to invest in stocks. To address this issue you may wish to consider if stocks are overvalued, if they are fairly priced relative to other opportunities, if there are military, economic or political events on the horizon that could trigger downside volatility, etc. This is a different type of inquiry which we will discuss further in the forthcoming ‘Equity Risk Premium’ essay.
  • The prudence of stock investing – or, in this case, avoiding stock investments – primarily depends on the investor’s personal economic circumstances. Think carefully about this example the next time you hear someone making a case for why this is a good or bad time to be in the market. Chances are this person knows nothing about your personal circumstances.

Bottom Line: Is the mistake of mismatching objectives and investments common? Many retirement plans permit participants both to self-direct their accounts and to make tax-favored withdrawals for the purchase of their first home. We suspect many prospective home buyers let their eyes get too big as they reach for brass ring of wealth accumulation.

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