Now that the dust is settling on the recent stock market volatility we can look back in a calmer and more reflective mood.
Let’s start with a simple question…
What can we learn after the events of last week, when the Dow Jones fell by 4.6% in a single day and the FTSE 100 dropped 9% from its peak of 7,778 in January?
That’s right, the volatility seen in the UK, US and around the world tells us precisely nothing new about investing. Stock markets rise and fall and after a lengthy bull run a correction was bound to happen sooner or later. Ironically, it was positive economic data, which caused the volatility, with markets worried that it could lead to a rise in the rate of inflation and consequently an increase in interest rates.
Frankly though, with Warren Buffet’s (Buffett is variously a business owner, investor and philanthropist) wise words ringing in our ears (“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years”) the reason for the volatility is so short term it’s insignificant over the length of time you should look to hold an investment.
To put it another way: Do you think anyone will remember last week’s events in 10 years?
No, I thought not.
However, the way the media reacts to such events is bound to shape the way some investors think. Therefore, if nothing else, the volatility provides us with a useful opportunity to remind ourselves of some investment fundamentals.
1. If you were really nervous, it’s probably time to think again
If you caught some of the more alarmist headlines it would be only natural for you to take more than a second glance.
Any immediate nervousness though should have been quelled by remembering some of the investment fundamentals we are discussing here.
These should either have been self-taught or drilled in to you by your financial planner. However, if these failed to provide sufficient comfort for you to get on with your day, safe in the knowledge you are invested for the long term, it’s probably sensible to revisit the risk you are taking with your investments.
2. Cash currently guarantees a loss
The common financial enemy we all face is inflation. It eats into fixed incomes and erodes the value of capital.
Cash provides the illusion of growth with the number on your bank statement getting slightly larger each year.
However, the only thing holding cash currently does is guarantee a real-terms loss.
At the time of writing the highest interest rate available on any fixed rate bond is 2.55% before tax (Source: Money Facts). That’s only available if you are prepared to tie up your capital for seven years and with the Consumer Prices Index (CPI) at 3% in December a real-terms loss will continue while interest rates remain lower than inflation.
3. Irrational behaviour guarantees a loss
Coming out of the market following a fall simply exchanges a theoretical paper loss to a cold hard cash loss.
Accepting that an emotional argument rarely trumps a logical one, I won’t give a detailed explanation of the sound theory which shows that investors who sell following a period of volatility miss out on future positive returns. However, I will point to research from Vanguard which shows that: “…US stocks have typically delivered above-average returns over one, three, and five years following consecutive negative return days resulting in a 10% or more decline. Results from non-US markets are similar.”
If you want to read more from Vanguard on this topic please click here.
4. Trying to time the market means getting lucky twice
The thought of being able to time the market, so you sit out the periods of volatility and are only invested during periods of growth, is certainly attractive.
Then again, so was the thought of dating Kate Moss when I was a teenager. Frankly both are about as likely!
Picking the optimum time to come out of the market, and then go back in, necessitates getting two decisions right. The danger of course is that our conditioning takes over and we hang on to cash for too long and miss a rising market. Or conversely, we get over confident, believe the bull run won’t ever come to an end and end up selling after a correction.
The likelihood of getting both decisions correct is minimal. Which is lucky, because you don’t need to. Providing you follow the next point…
5. It’s time in the market which counts
I make no apology for quoting Warren Buffett again. The man is worth over $80 billion (Source: Forbes), he’s worth listening to!
“Our favourite holding period is forever.”
In other words, you’re in it for the long term. And avoid decisions based on short-term volatility.
6. Focus on your aspirations and your plan
Money is simply a means to an end.
Everyone I work with who is achieving what they want from life or is on track to do so in the future, focuses on their plan. In the same way a bit of turbulence on the flight to your holiday destination won’t stop you arriving, investors understand that market volatility is natural and shouldn’t put them off their long-term financial plan.
Failed investors however put too much faith in their own ability to beat the markets. Kidding themselves that this time it’s different. If you want proof, look no further than those Bitcoin investors currently nursing huge losses and doing their best to convince themselves that one day their speculation will turn out ok.
That’s why last week taught us nothing
Those six lessons were as true when the markets fell in 1987 and at the turn of the millennium when the dot.com bubble burst as they were last week.
Providing your long-term objectives and aspirations remain unchanged, your strategy should too. In the longer term you won’t be able to point out last week’s volatility on a chart. It might sell newspapers and make great clickbait but, reacting irrationally to it won’t make you rich.
Have faith, remember the fundamentals and stick to the plan.
The value of your investment can go down as well as up and you may not get back the full amount invested.