Well, we've done it, folks! Despite COVID-19 and tens of millions of Americans unemployed, the NASDAQ and the NASDAQ have successfully completed their V-shaped recovery. At the end of the day, capital, not labor is the best way to build wealth.
In this post, I want to go through some key lessons from this most extraordinary and largely unexpected rebound. We are firmly back to bull markets, despite the economy still in ruins.
I'm not buying into this rally, but I continue to hold my pre-pandemic stock positions with wonderment and bewilderment.
As always, the goal is for all of us to become better investors in order to achieve financial freedom sooner, rather than later.
Key Lessons Learned From A V-Shaped Recovery
1) You might get lucky once, but it's hard to get lucky twice.
In mid-March, I got lucky calling the bottom of the S&P 500 in a post called, How To Predict The Stock Market Bottom Like Nostradamus. The post went through elaborate reasons why I thought buying below 2,400 was a prudent move. Between March 18 – 23, 2020, I invested about $200,000 into the S&P 500 when the index was between 2,300 – 2,500.
By the time the S&P 500 hit 3,000, I had sold 100% of the $200,000 I invested in March. As a result, I left 6% – 15% further gains on the table because I was selling stock on the way up once the S&P 500 hit ~2,800. Further, I took profits on some tech stocks like Tesla at around $850 because it had come back from the dead.
It is extremely difficult to know when to buy, know when to sell, and know when to buy back in. Therefore, don't bother trying to time the market with the majority of your investments!
Related post: Your Wealth Is Mostly Due To Luck: Be Thankful!
2) Limit your speculative money to no more than 20% of your entire portfolio.
You can’t outperform the S&P 500 if you only buy the S&P 500 index. The only way you can outperform (or underperform), is if in addition to your index position, you also pick stocks.
In my perpetual desire to outperform the S&P 500, invest in promising companies, and invest in companies that would never hire me, I've always used at least 10% of my portfolio to invest in individual stocks.
I worked in finance in San Francisco since 2001 and watched the technology sector consistently outperform. Therefore, I hedged by buying tech stocks. It's worked out well so far, but this is mostly due to luck. I've had plenty of examples where I've bought stocks at the wrong time and have lost hundreds of thousands of dollars as a result.
Professional money managers spend all day analyzing stocks and still mostly underperform. Therefore, there is little hope for the rest of us who spend 40+ hours a week doing something else.
If you limit a maximum of 10% – 20% of your overall portfolio to trying to pick winners and time the market, you'll probably be OK. You might outperform with some of your positions or you might end up losing all your money if you're a real buffoon. But even if you lose 100% of your 20%, you still have 80% left. It's the people who risk much more than 20% who end up getting into trouble.
80% or more of your portfolio should be invested in low-cost index funds for as long as possible. Invest the other 10% – 20% how you wish, with no expectation of beating the market.
3) Capital gains tax matters.
If I was smarter, I would have just held onto my ~$200,000 position for longer. The V-shaped recover could easily continue.
The ideal situation would be to hold on for one year, see the S&P 500 go up further, and pay long-term capital gains tax instead of short-term capital gains tax. Alas, I'm not that smart as I'm fearful the stock market has gotten far too ahead of itself.
Below is a chart that shows the significant difference between long-term and short-term capital gains tax rates once you start making over ~$157,500 per person. A 17% capital gains tax rate differential (32% – 15%) is huge, and should be avoided.
For those of you who earn more than $200,000 a year and have investment income or gains, it is even more important to hold onto your investments for the long term.
The 3.8% Net Investment Income (NII) tax hits investment income when your combined income and investment income breach $200,000 for individuals and $250,000 for married couples. Then you've got to pay 35% or 37% federal short-term capital gains tax as well as state capital gains tax.
Even if you hold long-term (over a year), your tax bill can still be huge. For example, in California, you would pay 20% federal +3.8% NII + 13.3% state = 37.1% tax if you have huge gains over the statutory threshold. Below are some net investment income tax examples.
4) Check your asset allocation each month to ensure congruency with your risk tolerance.
Losing hundreds of thousands of dollars by March 2020 hurt, but it would have hurt much worse had I lost millions.
If I was down $1 million or more, there would have been a much greater chance that I would have sold some stock near the bottom in order to not lose another $1 million. The S&P 500 had only gone down 32%, whereas, during the previous 2008-2009 financial crisis, the S&P 500 went down about 55%. This V-shaped recovery is a surprise because it is so quick.
By having an asset allocation that closely matches your risk tolerance, you will have a greater ability to not panic sell at the wrong time. Can you imagine selling close to the bottom and then going short? Ouch.
5) Don't fight the Fed.
Despite all the carnage in the economy, if the Fed explicitly says it will be the backstop and use whatever means necessary to prop up the capital markets, believe it.
I have never seen a more open and clear Federal Reserve that has been willing to support every asset class, as this Federal Reserve. During the time of Alan Greenspan, you couldn't figure out anything he was saying. He was a master of saying a lot while saying nothing at all!
Below is a beautiful V-shaped recovery chart of the NASDAQ.
6) Separate your financial situation from the markets.
Just because you got a divorce, lost your job, got a pay cut, or were bullied online doesn't mean the stock market should also suffer like you. The reality is, people are still getting married, finding new jobs, getting pay raises, and joining mobs to bully others every day.
For example, let's say you own a retail store that got forced shut by the government. Your revenue has dried up and you believe the only thing you can do is apply for a PPP loan and set up a GoFundMe page. That's limited thinking. Instead, you should think about who benefits from your demise and buy their stock instead as a hedge.
The more you can see the other side of the coin, the more rational you will be. The reality is that someone is always winning when someone is losing.
The people who shouted the loudest that the world was coming to an end near the bottom were probably short the stock market, missed out on huge gains until the correction, or were going through some very difficult times in their lives.
It's good to minimize social media and traditional media consumption during times of chaos.
7) Capital, not labor, is the way to go.
With tens of millions unemployed, it is clearer than ever that depending on labor as your main source of income is very risky. Everybody must do everything they can to build more income sources with their capital.
Ideally, you want to build your capital large enough where it is generating more passive income than your day job. In this situation, you have reached financial nirvana and no longer have to work if you don't want.
In order to build your capital large enough, however, you must of course save aggressively and invest prudently for a very long time. Shoot to save 50% of your after-tax, after 401(k) maximum contributions for 10 years. If you do, I promise you will feel more freedom than ever before.
Stop thinking the only way to provide for your family is to labor endlessly. Expand the way you think about generating wealth. Once you have your debt under control and have multiple income streams, you will have more courage to take advantage of a downturn and buy.
8) The stock market doesn't reflect the present economy.
To get rich, we must actively try to predict the future. By the time the future is known, the opportunity to profit will be too late. Trying to get an edge reading media headlines is not the way to go. Media headlines are always lagging indicators.
The stock market is a reflection of the economy 6+ months into the future. The V-shaped recovery is saying this will get better. On the one hand, we should all find solace knowing the stock market is predicting everything will be much better in the economy if we can just hold on. Expectations are high!
On the other hand, the stock market has been wrong in the past and black swan events do happen. Again, do not confuse your current financial situation with stock market performance.
9) You'll never lose if you lock in a gain.
Even if you don't time the bottom or the top correctly for maximum profits, so long as you're winning, you're winning. Greed has caused many investors to ride their winners back into the ground.
And if you take those less-than-spectacular winnings to pay for your child's education, buy a house, help fund your parent's retirement, or donate to a charitable cause, then you're going to keep on winning.
V-Shaped Recovery Is Still Undetermined
Investing in the stock market should be boring. All you've got to do is find your appropriate stock and bond allocation, invest accordingly, and hold for the long term. The longer you hold on, the richer you'll likely become.
But it's hard to hold on forever due to three reasons:
- Emotion, mainly fear and greed
- The desire to use profits to pay for life
- The fact that we can't live forever
With stocks, you are a passive investor, which is great and why dividend investing is my current #1 ranked passive income investment.
However, if you are like me and enjoy the process of actively creating more value, then investing in real estate and building a business feel more rewarding. There's no reason why you can't do all three.
Let's all be thankful there's so far been a V-shaped recover. It's possible the V turns into a U, but for now, let's enjoy things. Now it's time to get the economy back on track too.
Readers, what are some lessons you've learned from this incredible V-shaped stock market recovery?