As I write this month’s Insights piece, the financial markets are off to a rough start for the year. After the first week of trading, the S&P 500 is down 6%, international developed markets overall are off by 6.5% and emerging markets have fallen 8.3%. As long-term investors we know that volatility is the price we pay for positive, inflation-beating returns, but some nerves have been rattled understandably. What should we be doing in the face of such market moves?
To be sure, one thing we should not be doing is allowing day-to-day fluctuations in stock prices to derail a carefully crafted investment plan. The number one reason that individual investors underperform the market is poor timing decisions. The average investor tends to invest more near market peaks, when things have been going well for a while, and sell near market bottoms when everything feels gloomy.
In fact, a 2014 DALBAR study found that over the 20-year time period studied from 1994-2013, the S&P 500 returned 9.22% annually, but the typical stock investor achieved a personal return of only 5%. While fund expenses and trading costs account for some of the difference, investor behavior explains most of the 4.22% shortfall in returns.
To avoid the temptation to sell at the wrong time, it’s helpful to remember that there is actually an upside to these temporary market declines – they allow for a disciplined rebalancing strategy that effectively raises your future expected return. This is due to one of the ironclad rules of investing, which states that the price you pay for an investment directly determines your eventual return. This fact is easiest to demonstrate with an example using a fixed income investment.
Imagine a ten-year, zero-coupon bond that matures at $100. If you buy this bond for $75 today, you’ll earn $25 over ten years and your return will be 2.9% (compounded annually). But if the price of the bond suffers a 1/3 decline and you buy the same bond for $50, your return would jump to 7.2% per year. As you can see, there is a direct relationship between the price you pay and your final return. (Lower price = higher returns). Although stocks don’t have a set maturity date or value, the same concept applies to all investments. Declines in stock market prices increase your future expected returns, just as they do with fixed income investments.
It might also help to remember that the US stock market (as measured by the S&P 500 index) has never had a negative return for any 15-year period. In fact, the worst 15-year period concluded in February of 2009 with a positive annual return of just 5%. The total return for long-term investors who just bought and held for those 15 years was 107.9%. In other words, the value of their stock holdings and reinvested dividends had more than doubled during the lowest-returning 15-year period in US stock market history.
For those with a long-term investment horizon and a disciplined plan in place, usually the right response to stock market volatility is to tune out the financial media, avoid trying to time the markets and instead let them work for you over the long run. It can feel counter-intuitive at times but the evidence shows that for a more successful investment experience, what matters is not timing the market, but rather your time in the market.