The Power of Staying Invested Throughout Market Cycles
There are a number of reasons why a household would want to work with a financial advisor. Usually it boils down to achieving goals and objectives. Going deeper, there are always some underlying values behind those goals. As such, households want those goals and objectives achieved regardless of what happens in the market, economy, or world.
Because we want our clients to be successful, irrespective of external circumstances, we are writing this note to emphasize the importance of staying invested. One of the three primary risks that can derail any pre retiree or retiree from achieving their goals and objectives is behavioral risk. In fact, it may be the greatest risk. This certainly includes selling during a bear market because of fear or panic.
Seventy five percent of the time we are in a bull market (when the market goes up) and twenty five percent of the time we are in a bear market (when the market goes down). In order to realize those healthy long term returns that the market provides, one needs to maintain their market exposure throughout the bear market. No one knows the day or hour the market bottoms. That means market timers will exit and re-enter the market at the wrong time. There is no reason to lose money in a bear market. The only way to lose money in a bear market is to cash out during the bear market. The long term is made-up of a bunch of short terms (yes 25% can feel like a lot). It is necessary to be smart through those short terms in order to be successful in the long term.
The most important factor in total investor returns, even more than annual return percentage, is time in the market. The formula for compound interest is such that the number of time periods (usually counted as years) is the exponent. You don’t have to understand the math, but the exponent is the most consequential variable in the equation when it comes to return percentage. A change in it moves the needle more than a similar change in any other single variable. [P*(1+i)^n), where P is the principal, i is theannual interest rate, and n is the number of periods.]
· The above graphic shows the odds of the market falling over different time frames. On any given day, it is almost a coin flip whether the market is going to go up or down. As you go further out and extend the time frames, the chances that the market goes down decreases exponentially.
We can show the same phenomena for other time frames, but the chart above compares the S&P 500 (one of the best measures of the US market) over a two decade period, against an investment strategy that tracks the S&P 500, except that it moved to cash at the bottom of the 2008 bear market and stayed there for one year before venturing back into the market. If one would have stayed invested all the way through the Global Financial Crisis (GFC) to the present he or she would have earned 10.36% annualized returns on their US equity portfolio over the last two decades. The strategy that moved to cash at the bottom of the crisis and stayed there for one year before moving back into the market returned 7.46% per year. Compounding that difference over two decades adds up. Also, if they sold at the bottom of the market during the ‘07-09 GFC, that means they locked in about a 54% loss from the pre financial crisis market highs.
In the absence of an awareness of market history, moving to cash and staying there until things stabilize sounds somewhat safe, even appealing. In actuality, that course of action is one that is more likely to put at risk realizing your goals and objectives, which makes it (counterintuitively) the more risky course of action.
There are a multitude of manifestations of behavioral biases, but one of the most powerful and harmful is recency bias, where an investor projects their most current experience into the future. They may think “the market returned 20% the last couple of years. I can depend on that trend continuing.” That may lead an investor to take too much risk. Conversely, one may think “the market is down 30% from where it was 1.5 years ago. I better be safe and get out of the market.” Both strategies wrongly extrapolate the most recent past out into the future.