Treat Stocks Like Real Estate During A Market Crash

Although my stance on your personal home being an investment is well documented (it is not an investment), I don’t believe real estate itself is necessarily a bad asset class to allocate some of your investment dollars to. In fact, investing in real estate can be one of the fastest and most effective ways to grow your wealth. That being said, this article isn’t about real estate investing. Instead, we will use real estate, a physical asset that most people have at least a general understanding of, as a proxy for other, more complicated (misunderstood?) investments, in order to demonstrate that investments that seem very different on the surface may, in fact, have quite a bit in common. With that in mind, I’d like to present the following story:

After reading the book Rich Dad Poor Dad, Judy felt inspired to begin investing in real estate. Being a woman of action, it didn’t take her long to conduct adequate research, save the required money, and find the perfect 4-unit rental property to buy. She purchased the property for $300,000 and quickly rented out all four apartments to tenants. The rents were set high enough to cover all of the property’s expenses plus provide her with a reasonable amount of passive income. After only six months of owning the property, its “paper value” (the value it would be appraised and/or sold at) had grown a full 5% to $315,000! Her decision to invest in real estate seemed to really be paying off! Or so she thought…

Exactly two years after Judy acquired the property, the housing market experienced a massive decline and the paper value of her investment dropped all the way down to $200,000. Although the 4 tenants were still in place and paying rent on time, the property’s value was now over 33% below what Judy paid for it! Should Judy quickly sell in order to avoid any more large blows to the value of her investment? Once she sells, she could simply wait for the market to improve and then get back in, right?

Let’s see.

• The drop in value is only on paper.
• Judy still owns the property.
• The rent money from the tenants is still enough to cover all of the property’s costs.
• Judy is still receiving monthly passive income from her renters to spend however she pleases.
• Due to her research, Judy knows that, historically, the housing market has always eventually recovered from all previous market declines, usually within a relatively short amount of time.

Would it make sense for Judy to sell her investment property for an actual loss of $100,000 in order to avoid additional losses on paper?

The answer seems pretty obvious. There's very little incentive for Judy to sell the property, especially at a loss. The drop in value is clearly temporary and maintaining ownership doesn’t cost her anything out of her own pocket. On top of that, she’s receiving regular passive income. The right course of action is clear. Judy should continue holding the investment property, continue collecting the periodic passive income, and sit back as the market recovers and, eventually, increases further over the long term.

While it’s evident that Judy should hold onto her investment property through a market decline, what about stock investments? What if instead of real estate, Judy had invested in a stock market index fund? How would things be different…

Judy is in a panic. It’s been a full two years since she invested her money into the stock market and her investment is showing nothing but red. She is down by a whopping 33%, and has no idea what to do! Should Judy quickly sell in order to avoid any more large blows to the value of her investment? Once she sells, she could simply wait for the market to improve and then get back in, right?

Let’s see.

• Although it may feel different, the drop in Judy’s stock investment’s value is only on paper, just like it was for her real estate investment.
• Judy still owns every share of the stock fund that she purchased.
• There’s essentially no cost* associated with simply owning stocks, so holding this investment doesn’t cost Judy anything.
• Judy is receiving regular passive income from dividends to spend however she pleases.
• Due to her research, Judy knows that, historically, the stock market has always eventually recovered from all previous market declines, usually within a relatively short amount of time.

(*Some index funds do have fees associated with owning them called "expense ratios". These fees tend to be extremely low, ranging from a high of around 0.2% all the way down to 0.04% or less. The dividend income from an index fund will typically be orders of magnitude higher than any fees.)

Hmmm. This all sounds pretty familiar…

That’s right, this situation is almost identical to that of the real estate investment! Therefore, just like we concluded with her real estate investment, it is obvious that Judy should hold onto her stock investment during a market decline. The alternative is to lock in an actual loss (as opposed to a loss on paper) and lose out on the dividend income and other benefits of the investment. Once again, the right course of action is quite clear.

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