Some investing years go out with a bang. 2018 seems to be ending with a lot of confusion. What can we – or should we – think about what we have experienced over the past several months? And how should we approach 2019, and beyond?
There are five important lessons for us to remember:
Markets Can Be Volatile
We say this all the time, but it can be difficult to really internalize. That’s especially true now because we have experienced relatively low volatility over the past several years. And human cognitive tendency is to overweight recent experience, while discounting experiences in the more remote past. Given this cognitive distortion, it’s important to try to separate what we feel (especially after watching stock market coverage on TV) from what we know from long-term market research.
What we know is that the volatility that we’ve seen during the second half of 2018 is normal, even expected. That isn’t to say that how we feel about it isn’t understandable (see below). But taken in historical context, there’s nothing in this recent experience to indicate that something is fundamentally ‘wrong.’ Thunderstorms may be scarier than calm sunny days, but they’re part of a natural weather ecosystem.
Risk Tolerance Can Be Difficult to Gauge
We should also talk about how we feel about the process of investing.
Before we agree on a portfolio strategy with each of our clients, we are careful to talk about its potential long-term behavior, both the downside as well as the upside. I am frequently a voice of restraint in these conversations, urging clients to think not only about their potential for long-term gain but also about how they’re likely to feel when markets go down, as they inevitably do. It can be a difficult argument to make.
Yet research into behavioral psychology has also taught us that our perception of risk changes over time, that it largely depends on recent experience rather than on historical data and statistical measures. As a result, it’s normal for investors to feel optimistic after a long market rally and – conversely – to feel terrified after a significant market decline. But ‘natural’ behavior in this context leads to the most basic of investing mistakes: the tendency to ‘buy high and sell low.’ It takes perspective, experience, and emotional self-management to do the right thing from an investment perspective: in the words of Warren Buffett, to “be fearful when others are greedy, and be greedy when others are fearful.”
That said, there can be very rational reasons to adjust one’s long-term risk tolerance. If this is a topic that you’d like to revisit, let us know. We’ll be happy to have an in-depth conversation with you about it.
We Can’t Time the Market
In the short term, we just can’t always see things coming. At the end of 2016, after the election, a lot of individuals were ready to liquidate their entire portfolios and sit out what they thought would be the inevitable world cataclysm. Instead, what we experienced in 2017 was the best market – across virtually all asset classes – that we’ve seen since the financial crisis. So much for predictions.
Sometimes our expectations play out, but frequently they do not. We saw that this past week when the Dow Industrials jumped up almost 5% in a single day. Who was expecting that? Such ‘big market days’ are impossible to predict. As a result, staying out of the market until it feels safe to be invested is a sure way to miss market opportunity. And missing just a few such days during an investment period can mean missing a huge proportion of the overall gains that were available, as the following graph shows:
The bottom line: uncomfortable as it feels, the right thing to do is to stay invested.
Diversification is Important
When international stock returns lag, as they did in 2018, investors may feel tempted to double down on their home market. But over long periods, consistent exposure to both US and non-US equities is a more successful strategy.
We can examine the potential opportunity cost associated with failing to diversify globally by reflecting on the period in global markets from 2000–2009. During this period, often called the “lost decade” by US investors, the S&P 500 Index recorded its worst ever 10-year performance with a total cumulative return of –9.1%. However, looking beyond US large cap equities, conditions were more favorable for global equity investors as most equity asset classes outside the US generated positive returns over the course of the decade. (See below.)
Global Index Returns: January 2000–December 2009
Expanding beyond this period and looking at performance for each of the 11 decades starting in 1900 and ending in 2010, the US market outperformed the world market in five decades and under-performed in the other six. By holding a globally diversified portfolio, investors are positioned to capture returns wherever they occur.
The Pundits Are Frequently Wrong
You’ve probably heard from ‘experts’ recently who purport to know exactly how both the world economy and global markets are going to perform over the next 2 – 3 years. They can sound very convincing, especially when their outlook is negative. (Studies have shown that having a negative outlook appears ‘smarter’ to others.) The problem is, such predictions are frequently wrong.
For example, one such national pundit is predicting a years-long recovery period from the bear market that we’ve been experiencing. But when we recently plotted the time it took markets to rebound after price drops of varying severity, the results weren’t that simple. The data clearly show that, on average, markets recover within 12 months in all but the most
In addition, we looked at historical data on the size of the market recovery after a significant decline.
Put another another way, when the market rebounds, the rate at which it does so can be very high. This second chart shows that the speed of the rebound has always been a double digit annualized return. If you tried to time the market and didn’t reinvest in time, you would have easily missed some very large gains. So though we don’t know exactly what to expect in the future – or when to expect it – experience and historical averages strongly support a strategy of sticking with a solid investment strategy through a market decline in order to catch the market upswing on the other side.
Thanks to Jon Hsu, who contributed to this article.