I hope everybody checked out the ChooseFI Roundup episode in early January, where I talked with Jonathan and Brad about the recent stock market volatility. They invited me for a short appearance on their Friday show after reading my piece from two weeks ago. That post was on how the recent stock market volatility will probably not obliterate the FIRE community. One issue that came up is the potential for people on their FIRE path to actually benefit (!) from the drop in the stock market. How can one possibly benefit from a drop in the stock market? It’s certainly not a guarantee. It depends on the personal circumstances and on the nature of the stock market drop! Generally speaking:
- How permanent or how transitory is the drop in the market? If your portfolio dropped because one of the equity or bond holdings went bankrupt (or you were a victim of the OptionSellers meltdown) then that’s not something to cheer about. It’s about as permanent as it gets. Not good for the investor! But frequently, the market drops without much of a change in fundamentals. Be it a “flash crash” that reverses within a few hours or even minutes or the (likely) overreaction of the stock market drop in December, one could argue that since nothing (or not much) changed in the fundamentals (GDP growth, earnings growth, etc.) the drop may be only temporary and will eventually revert to the mean. Or even during a recession (the definition of weaker fundamentals!) stocks often overreact on the downside and then stage a strong comeback, i.e., return expectations going forward could be higher than long-term average returns. In other words, that paper loss you see now could be at least cushioned by higher returns on your additional savings going forward. And if this admittedly uncertain advantage of higher expected returns is large enough and over time more than offsets the paper loss then we could be looking at a net gain.
- How far along are you on your path to FIRE? The further along you are the more damage a bear market will cause even if you can expect a bounce in future expected returns from a transitory shock to the market. On the other hand, if you’re just starting out saving for retirement and all you lost is a few hundred or thousand bucks in your 401k/IRA and you still got 10-15 years ahead of you then you might benefit from the drop!
So, in other words, if the loss in your existing portfolio is offset by enough of a rise in future expected returns, then a drop in the stock market can be a net positive. Seems pretty obvious from a qualitative point of view. But quantitatively? How early is early along the FIRE journey? How much of a rise in expected returns do we need to make this work? Even if there isn’t a net benefit, how much of the paper loss is at least cushioned by higher future returns? These are all inherently quantitative questions. This blog post is an attempt to shine some light on the math behind the tradeoffs…