When stock markets are volatile, a natural instinct is to sell, or move your investments. But, as history tells us, this could really damage your future returns. Standing firm and resisting the temptation to tinker with your portfolio as its value shifts – when it’s up, as well as when it’s down – is the cornerstone of successful long-term investing.
Bulls and bears: the unpredictable beasts
Some investors plan their moves around what are known as bull markets and bear markets. A bull phase is when a confident market climbs more than 20% in value, normally characterised by rising share prices, high volumes of trades and more companies entering the stock market. A bear market is the opposite, meaning this phase begins after a 20% decline in the value of the stock market.
If you’re trying to time your investments around these, the idea is to buy during a bear when prices are low and sell during a bull when prices are high. The problem with this strategy is knowing when the market has bottomed out (the time to buy) and when it’s at its peak (the time to sell).
Take the performance of the Dow Jones index after the 2008 crash, for example.
Around the middle of 2008 the index fell from 13,000 towards the 11,000 mark before staging what looked like a recovery back up to 11,500. If you decided this was the bottom of the cycle and signalled it was the right time to buy, you’d have been wrong. Just look what happened next. The Dow fell further to 8,000. It then dropped another 1,000 points in the first part of 2009 before it began its recovery.
In 2015, the S&P 500 hit a record high, nudging above its 2007 peak. Since then we have seen US and UK stock markets fall below those levels, but it would be foolish to assume this is setting a precedent for things to come in 2016.
Time after time
The lesson is clear: while it’s true stocks markets rise and fall, predicting when, for how long, and by how much is fruitless. Keeping calm amid market volatility and maintaining a long term view is an important part of investing.
Financial analyst Dana M D’Auria at Symmetry Partners warns, “Most people aren’t going to outsmart the market. The goal is to buy low and sell high, but investors are notoriously bad at timing and tend to do the opposite.”1
In it for the long haul
There is strong evidence that stock markets, such as the FTSE 100 or the S&P 500, are highly likely to grow over the long term. Despite the periods of significant decline, there are much longer periods of substantial growth (as shown in the chart below). But many investors fail to embrace the benefits of long-term investing.
Another common misconception is that long-term reliable growth, as we have seen with the FTSE 100, applies to shares in global, established companies. Yet there are countless examples of big businesses that have gone bankrupt, leaving their shareholders’ investments in tatters.
Investing in individual stocks can be a risky game, which is why we advocate having a diversified portfolio that spreads risk and your chances of benefitting from good gains by putting your money in to a wide range of investment assets, across many countries and industry sectors. Our medium-risk portfolios typically have exposure to over 2,500 underlying securities, spread throughout 30 or more countries.
Trusting your own judgment: the problem of selective insight
Investors’ judgment can also be skewed by ‘confirmation bias’. This is an emotional part of the decision making process, which causes us to behave in unpredictable or irrational ways.
Essentially, if you’re on the lookout for a correction or a dip in the market, your selective perception takes over, meaning you’ll start to up-weight in your mind any signs you see that support your thesis and ignore those that cast it in doubt.
Similarly, there is ‘hindsight bias’, where people tend to reconstruct memory to prove they knew something all along. Of the 2008 crash, Nobel Prize-winning psychologist Daniel Kahneman asserts: “The biggest mistake to make was to say that it was predictable. Highly intelligent people failed to make that prediction. There were many who thought it might happen and then after the event they say they knew it was going to happen. That is a misuse of the word ‘know’.”2
So what do you do when the market endures a fall, as it will undoubtedly do? When the stock market collapsed in 2008, many investors panicked and offloaded their shares. But the reaction of many top financiers and investment managers during a recession is usually to hold on tight and ride the storm.
Slow and steady wins the race
Markets compensate investors over time. Although you may have to sit tight while the value of your portfolio declines an ugly 25% in a single year, historically stocks yield a return of around 5-10% per year over the long term3.
What happens in the stock market on a day-to-day basis isn’t half as important as some corners of the financial news might lead you to believe. While investors are often encouraged to take an active approach, chasing performance is symbolic of another often misplaced belief – that past performance is an indication of future success.
Risk warning
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance
Sources
1. 3 Investors Confess: What I’ve Learned From The Ups And Downs Of The Stock Market – 19th November 2013
2. The thought father: Nobel Prize-winning psychologist Daniel Kahneman on luck – 18th March 2014
3. MSCI World in GBP, 12th December 1971-30th June 2014
Image: Andrés Nieto Porras
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Kayla Kerr
Kayla Kerr writes on a variety of financial and lifestyle topics for Nutmegonomics. Kayla can be found on twitter @kaylasiobhan.Other posts by Kayla Kerr