Over the past few months when speaking with friends and family I’ve had one question that has repeatedly been asked of me. Should I sell out of everything and wait for the economy to get better before getting back into the market? It’s a great question and not surprising as most of my friends and family aren’t that familiar with market mechanics and how they behave from a historical standpoint. I’ve told them the same thing I always tell clients and that is to “stay the course”. Today, I’d like to share some data to help visualize why I nearly always respond this way.
We always begin with diversification. The split between stocks, bonds, and alternative asset classes will be the primary driver of returns over long periods of time. The ideal mix varies from person to person based on several factors. Once we determine the appropriate asset allocation, we typically do not like to make sweeping changes without some shift in goals or life situation. We go into investing understanding that stocks are more volatile than bonds, which are more volatile than cash. We also understand that stocks typically have higher returns than bonds, which typically have higher returns than cash. When we say “typically”, what we really mean is over long periods of time. Stocks can fluctuate wildly over the short term.
“I’ve got a few clients who always try to time the market and get out of stocks when things get scary and get back in when things are looking up again. Please don’t do that”
In the short term, stocks (and bonds to a lesser extent) are unpredictable and often have wild swings to both the upside and downside. The chart below shows an annual range for stock returns of -39% to +47%, going back to 1950. Bonds have a wide dispersion of 1-year returns as well, ranging from -8% to +43%, but note the range is tighter than stocks (with much more limited downside). As recently as March 2020 the stock market circuit breakers kicked in and trading was halted because the market had dropped more than 7% in one morning. This happened 3 times that month and saw daily declines of between -7% & -12%. For comparison, Q1 of this year was the worst quarter for bonds in around 40 years and it was down around 7% also. The point here is that a really bad day in stocks is normally like a really bad year in bonds. Bonds can (and do) fluctuate in value, but typically have a low correlation to equity markets. Meaning that in a normal environment when stocks go down, bonds typically do not. Over longer periods (10-20 years) they become much more predictable. I’ve attached a chart below to illustrate this.
On average, over a 5-year period stocks typically return somewhere between -3% and 28%. This means there is a chance you could lose money over the next 5 years investing in stocks. You’ll notice bonds have a tighter range of returns with -2% to the downside and 23% to the upside.
Now we get into the fun part – diversification. Look back up at the same 5-year chart for a portfolio equally split among stocks and bonds. Going back to 1950, there have been no rolling 5-year periods where a 50/50 portfolio has lost money. You can also see that over a 20-year period, the floor on returns for a 50/50 portfolio has been 5% with an upside of 14%. This is what drives our buy and hold mentality. We know that a diversified portfolio has always made money if you stay the course.
I’ve got a few clients who always try to time the market and get out of stocks when things get scary and get back in when things are looking up again. Please don’t do that. I like to share this next chart with them to show how market timing typically damages your portfolio more than it helps.
This chart shows a shorter period than the first but captures the world in which we saw the dotcom bubble burst, the great financial crisis play out over several years, and the covid drop in 2020. You’ll notice the average investor made around 2.9% over this 20-year period while a diversified portfolio made around double that. The reason is that the best days typically happen while you are out of the market. By the time people are comfortable enough to get back in, the best days are already behind us. Below I have one more chart that shows the impact of missing out on the best days. You only have to miss the best 20 days over a 20-year period for your returns to drop down near that “Average Investor” return in the chart above.Hopefully this gives you a little more insight on why we’re always encouraging people to “stay the course” on their investment strategy.
