Apply logic when markets begin to wobble
It can be tempting to switch from equities to cash when markets start to look shaky, but history tells us that fortune favours those who hold their nerve.
Tim Smith, Business Development Manager at Quilter Cheviot explores this point.
The COVID-19 pandemic has impacted on every aspect of human life from physical health and emotional wellbeing to financial security. So, it’s understandable that investors’ confidence in financial markets may also be dented; many have looked to consolidate their financial position by moving out of equities and into cash. Yet swapping long-term growth potential for short-term capital security can prove costly.
Inflation surge
Inflation is the biggest current economic talking point, with current and projected figures spooking both markets and investors. The headline figure of the UK’s preferred measure of inflation, the consumer prices index, vaulted to 9.4% in June (11.8% for RPI)1 and we’ve all felt the effects of it continuing to rise since then – despite the official figure for CPI decreasing to 8.2% for June in figures released on 20th July.
Across the Atlantic, US inflation has surged to a 39-year high of 9.1%2.
The long-anticipated return to rising inflation is proving a dilemma for Central Banks. On one hand, corrective action is needed to prevent inflation from spiralling out of control. On the other hand, raising interest rates too aggressively in a bid to stem further inflation will hit the purse strings of consumers. This comes at a time when many individuals and families are still in the process of re-stabilising their finances after seeing businesses and livelihoods hit hard by the pandemic.
Market shave reacted to inflation concerns by showing signs of fragility. In the US the S&P500 has dropped almost 20.6% since the start of the year3, it’s worse first half year since 1970. This volatility is spilling over into other global markets, the MSCIs All-Country World Index has fallen 20% over the same period4.
Reacting with logic
Watching a portfolio lose value over a short period of time can provoke an understandable urgency to take corrective action to protect wealth in the event of uncertain markets. This is a natural and primitive response, which in psychology theory is termed loss a version.
The theory asserts that humans have a cognitive bias where the pain of losing is psychologically more powerful than the pleasure of gaining. The despair of losing an entire investment portfolio is, therefore, likely to endure for longer than the joy of crystallising a sizeable gain.
The key, however, is to apply logic. The way markets plummeted during the 2008 global financial crisis offers a case in point of what can happen when economic conditions become severe. Indeed, the crisis left a bitter taste in many investors’ mouths, but the way markets have rebounded in the decade since emphasises that making rash, short-term investment decisions – such as moving from equities into cash– can cause lasting damage to portfolios’ performance.
Recent history delivers another powerful lesson on the benefits of blocking out short-term noise and retaining focus on long-term goals. At the beginning of 2020, as the severity of the pandemic began to be understood, the UK equity market began a fall of 35%, from its peak in mid-January to the trough on 23 March 2020, for the first time in more than a decade. Yet fast forward just a few months to the end of June, the UK market had rebounded 24%, steadying to see out 2020 12% lower than at the start of the year. During 2021, despite the effects of the pandemic still being felt, the UK equity market climbed 18.7% – its highest annual rise since 2016.
Timing error
Switching from equities to cash when markets are bearish is based on the premise that markets can be timed. The most lucrative way to invest is selling stocks when they are high and buying them when they are low, or ‘buy the dip’ as it’s commonly known.
Timing the market can seem alluring – everyone loves a bargain – but it’s a tactic that is rarely applied with any accuracy.
The difficulties of timing the market were identified more than a century ago by French mathematician, Louis Bachelier. In his PhD hypothesis, entitled ‘The Theory of Speculation’, published in 1900, Bachelier posited that market movements are inherently random, and even with the best will in the world cannot be predicted with any true accuracy. This known as the random-walk theory.
There are real risks to being overweight in cash. Given that interest rates, despite starting to rise on both sides of the Atlantic in a bid to curb inflation, remain close to historic lows, any money held in cash will see its buying power eroding in real terms. The US Federal Reserve is poised to continue to implement several rate rises during the course of 2022, but interest rates will almost certainly continue to lag inflation.
Investors should resist being influenced by market behaviour and revisit their initial and ongoing objectives. Prudent investment planning is not about buying and selling to capitalise on each and every transient market event. Instead, portfolios should be tailored to each investor’s specific investment objectives, investment time horizon, appetite for risk, and capacity to bear financial losses. Portfolios should be regularly monitored and reviewed – at least annually – against investors’ goals. But, as stressed above, churning equities for cash to protect portfolio assets from potential dips could result in missing out on any potential upswing once markets rebound.
Investing would be a far easier pursuit if markets moved in a linear upwards trajectory, but we know from experience this is not the case. It would also be easier if cash deposit rates out stripped inflation, but this is also not the reality and is unlikely to be for some time. It can be tempting, and indeed reassuring to exit the market when it begins to wobble, but history tells us that holding one’s nerve is not only the best course of action, but often the safest.
Perseverance pays – the case for staying invested
Time in the market beats timing the market. This well-known maxim encapsulates arguably the most important piece of investment advice – to stay invested – and is particularly timely given the current environment and recent drops in both equities and bonds. Evidence shows that remaining invested for the long term is one of the best things you can do for your overall wealth.
Thus far, 2022 has been a challenging year for stock markets with sizeable declines seen in global equities as the highest level of inflation in a generation has caused central banks to embark on rapid monetary policy tightening. Occurring against a backdrop of slowing global growth, calls for a period of stagflation have gained credence and grown louder.
However, investors should maintain a long-term horizon and look through short-term headwinds. Staying invested allows you to benefit from the growth in businesses and the economy over time, and while it can be tempting to take money out of the market in the short term, history shows it is highly likely to deliver lower returns overall.
To help illustrate this we put together three charts of historical stock market performance over a long-term horizon.
Chart number one: markets trend up over time, despite several bear markets
Our first chart shows the performance of US shares from the end of December 1979 to the end of April 2022. Overall, the picture is encouraging with investors enjoying positive returns during the period, despite several significant declines along the way –the market experienced seven bear markets, defined as a market decline of 20% or more. Downturns aren’t rare events and typical investors, in all markets, will experience many bear markets during their lifetime.
Source: Refinitiv Datastream. Based on US MSCI Total Return index from 31 December 1979 to 29 April 2022.
Chart number two: the impact of missing the best days in the market
Our second chart demonstrates the negative impact of missing the best days in the market. While it might seem preferable to avoid bear markets, many of the largest daily gains occur during these periods. Missing these days by divesting into cash would have a clear and significant detrimental impact on your overall returns.
The bar on the left-hand sideshows how much a £1m portfolio invested in UK shares (reinvesting dividends – see chart 3 below) at the start of the year 2000 would be worth now – it would have more than doubled. The bars to the right show how much it would be worth had you missed the best 10, 20 and 40 days in the market. Notice that the portfolio would have lost value during this period had you missed the best 20 or 40 days in the market.
Source: Refinitiv Datastream. Based on UK MSCI Total Return index from 31 December 1999 to 4 May 2022.
Chart number three: The dividend difference
Dividends are payments made by companies to shareholders and can account for an extremely significant portion of long-term returns. Reinvesting these dividends allows them to compound and can provide a major increase to overall returns. For instance, reinvesting dividends can more than double the overall return, as has been the case for UK indices since the turn of the millennium. The chart below shows the performance of £1,000 invested into UK shares and US $1,000 invested into global shares, with dividends reinvested or paid out from the end of December 1999 to the end of April 2022.
Source: Refinitiv Datastream. Based on MSCI UK and US MSCI price and total return indices from 31 December 1999 to 29 April 2022.
Critically, dividends are often paid at regular intervals and therefore if you try to time your entry in and out of markets, you may miss these payments (there can also be minimum holding periods to receive dividends). Missing dividend payments would have severely diminished your investment returns over the past 22 years – you would have received the returns shown above in blue, rather than the returns shown in orange.
In conclusion, there have been clear benefits to remaining invested over the past 40 years. Historical results should not be seen as a guarantee of future performance, but the rationale behind this approach is sound. Looking through short-term volatility and maintaining a long-term focus has proven to be a winning strategy, largely due to not missing the best days in the market and the reinvestment of dividends.
With all of this logic applied its still entirely understandable why these wobbles occur when emotions get involved. It is, after all, your hard-earned money that you are hoping to use for your lifetime goals and objectives.
This is where your financial planner really comes in to their own – keep talking to them, keep reminding yourself of those conversations previously had around the potential volatility of your portfolio. Riverfall are more than happy to speak with you at any point, don’t bottle any concerns you may have, talk about them and revisit the logical side of investing monies to allow you to hold your nerve.
The value of investments and the income they produce can fall as well as rise. You may get back less than you invested.
1 https://www.ons.gov.uk/economy/inflationandpriceindices#timeseries
2 https://tradingeconomics.com/united-states/inflation-cpi
3 https://www.bbc.co.uk/news/business-62005360
4 https://www.theguardian.com/business/live/2022/jun/30/uk-house-price-growth-inflation-crypto-gdp-opec-oil-business-live#:~:text=Global%20stock%20markets%20wrap%20up%20torrid%20first%20half%20of%202022,-Global%20stock%20markets&text=MSCI’s%20All%2DCountry%20World%20Index,%2413trn%20off%20share%20values
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