Five principles of smart investing

06-30-2022
Five principles of smart investing

Stick to the proven basics to win the battle of the bear

 

Investors have had to grapple with a series of difficult events to start the year, with heightened geopolitical risks, rising inflation, changing central bank policies, and ensuing volatility in capital markets adding up to greater overall uncertainty about where the markets will be headed for the rest of 2022. 

This recent turbulence has made the role of financial advisors even more critical. In fact, recent research from Vanguard found that investors believe financial advice provides a perceived value-add of 5% to annual performance versus “going it alone.”1

While investing in the stock market is typically a prudent choice for investors seeking long-term growth, sharp drops can test the patience of even the most disciplined investors. Here are five research-tested strategies to help investors navigate through periods of uncertainty and resist the temptation to “do something.”

1. How geopolitical risks affect stock returns

With a perspective of recent geopolitical events in Ukraine, investors worry that geopolitical developments may significantly impact asset returns. However, upon examining various geopolitical events over the past 60 years (Chart 1), we find that while equity markets may react negatively to the initial news, geopolitical selloffs are typically short-lived and returns over the following 12-month period are largely in line with long-term averages.

2. Short-term volatility and bear markets are inevitable, but a long-term focus has been a winner

Short-term volatility has always been part of investing. Extreme and extended cases of volatility have frequently coincided with market pullbacks. But investors should focus on the long term.

Research shows that despite periods of high volatility that have coincided with market pullbacks, equity markets have climbed over the long term (Chart 2).

From December 31, 1982, through December 31, 2021, the S&P 500 and MSCI World indexes faced several periods of extreme market volatility, most notably after the stock market crash of 1987, the global financial crisis in 2008, and the start of the Covid-19 pandemic early in 2020. However, despite sharp market pullbacks that coincided with these periods of volatility, both the indexes have continued to move on to greater heights (Chart 3).

3. Longer-term investing reduced likelihood of a negative return

History shows the longer investors stay invested, the less the likelihood that they will earn a negative return.

Over a 10-year holding period, a portfolio of 60% stocks and 40% bonds hasn’t had a negative nominal return (not accounting for inflation) and has had significantly less likelihood for after-inflation negative returns than over a shorter holding period. Moreover, many investors think of U.S. Treasury bills as safer than equities. But when adjusted for inflation, Treasury bills have been more likely than stocks to have negative returns. And this finding is even more relevant in the current high-inflationary period.

4. Investors shouldn’t overreact to bear markets

While bear markets can be unnerving for investors, on average they have been much shorter than bull markets and have had far less of an effect on long-term performance. From January 1, 1980, through December 31, 2021, the average length of a bull market has been nearly four times that of a bear market. The depth of losses from a bear market has paled in comparison with the magnitude of bull-market gains. That’s a major reason for sticking to a long-term investing plan. Losses from a bear market have typically given way to longer and stronger gains.

5. Investors shouldn’t try to time the market. It’s harder than it looks.

Timing the market and knowing when to pull money out and put it back in is incredibly difficult. One major reason is that investors run the risk of missing out on strong performance, which can seriously hamper long-term investment success. Historically, the best and worst trading days have tended to cluster in brief time periods, often during periods of heightened market uncertainty and distress, making the prospect of successful market-timing improbable .

Our research shows that the best and worst trading days often occur within days of each other. Nine of the 20 best trading days as measured by the S&P 500 Index from January 1, 1980, through December 31, 2021, occurred during years of negative total returns. Meanwhile, 11 of the 20 worst trading days occurred in years with positive total returns, another sign of the futility of market timing.

Finally, as an investor, you cannot time the market and you cannot control the market. 

What you can do is control your asset allocation, diversification and your costs or the investment fees you pay. No matter the market situation, stick to four enduring investment principles 

  1. Set appropriate investment goals
  2. Develop a suitable asset allocation using broadly diversified funds 
  3. Minimize costs or your investment fees, and finally;
  4. Maintain perspective and long-term discipline. 

Put simply, stay the course!

Notes

1Sources: Vanguard and Escalent, 2021. https://www.vanguard.ca/en/investor/insights/robo-or-human-advice

Bilal Hasanjee, CFA, MBA, MSc Finance, is Senior Investment Strategist at Vanguard Investments Canada.

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