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Ride out the storm

04 May 2016

Evidence shows that holding your nerve during stormy market conditions can pay dividends for investors in the long run.

In 2013 – long before the latest bout of stock market turmoil – a team of behavioural economists at Barclays produced a paper with a highly intriguing title: Overcoming the cost of being human. The thesis argued that investors are their own worst enemy when they allow emotions to get the better of their reasoning.

People often make less than they should from investments by buying or selling at the wrong times. In fact, they often make avoidable and unnecessary losses when they become panicked and reverse investment decisions prematurely. It is part of our genetic make-up to react quickly to fear, which is why so many investors, having bought the right funds for the long term in a period of calm, then sell them at the first sign of market turmoil.

It can happen to anyone. During the opening weeks of 2016, when a market meltdown came out of a clear blue sky, it made even hardened market professionals take decisions based on fear rather than logic. However, all the statistics of long term trends show that if we could curb our fear, we would be much better off.

The Barclays paper contains a heat map of movements in the MSCI World Index of 24 developed world stock markets for the 40-year period from 1970 to 2010 – the index is a proxy for a geographically diversified share portfolio.

This analysis shows that four-fifths of all losses are incurred by investors with a holding period of less than five years. However, investors who were willing to ride out initial volatility and hold on for 12 years made a profit, whether they bought originally at a market peak or a market trough. Trying to time the market, by buying in troughs and selling at peaks, has little long-term value because the highs and lows become less relevant with the passing of time. Periods of market turmoil – such as the 1987 crash, or Black Wednesday in 1992, when the UK was ejected from the Exchange Rate Mechanism – barely show up on a chart of long-term trends.

Three of the recognised global authorities on long-term investment returns are London Business School academics Elroy Dimson, Paul Marsh and Mike Staunton. They compile what is known as the DMS database1, published every year by the Credit Suisse Research Institute. The message of their work is that the essentials of success are to hold for the long run and have a diversified portfolio. There are, however, no absolute guarantees.

Indeed, this year’s database illustrates the truth of comments made by the great economist John Maynard Keynes, who said that markets might remain irrational longer than investors can remain solvent. Hence the key question: when talking about the long term, how long do we mean?

The Credit Suisse study helps here. It shows that in the UK, from 1900 to 2015, shares returned an average of 5.4% per annum, while bonds delivered 1.7% and cash 1%. However, it also underlines that there can be periods of underperformance, like the one we are currently living through. Looking back, we can now see how spoiled we were in the 1990s: the Credit Suisse report shows equities delivered 11.5%, bonds 9.7% and cash 4.6%. A long-term focus is essential, but some long-term investments are better than others.

The figures also underline the need to diversify because individual markets can go sour for very long periods. Japan is the obvious contemporary example. Its stock market, the Nikkei, peaked at 39,000 way back in 19892 before falling more or less steadily to around 9,000 in 2002. While it has got back above 20,000 on several occasions in the past quarter of a century, it has generally fallen back and never come even remotely near its all-time peak.

Few investors like these periods of volatility, but they are becoming more frequent, as innovation makes it possible to deploy the world’s capital at the touch of a button. The mood swings of the markets when they think the economy is slowing, or that an oil price shock will be damaging, are more dramatic than they used to be because globalisation means markets are far more synchronised. Advances in technology mean that investors can deploy more money more quickly, as their fear dictates. Where investor behaviour may have caused light ripples in the markets 30 years ago, now it can create tidal waves around the world.

We may not like it, but we have to learn to live with it. We may not like volatile markets but in truth we have to learn to live with them. History is firmly on our side in suggesting that the stock market should be home for a reasonable proportion of our money. Coping with volatility is the price we have to pay for the prospect of good long-term returns.

Patient investors, with a diversified portfolio of assets, should be able to ride out the volatile storm.

 

1 Credit Suisse Global Investment Returns Sourcebook, 2016

2 www.tradingeconomics.com, 2016

 

Past performance is not indicative of future performance.

The value of an investment with St. James’s Place will be directly linked to the performance of the funds selected and may fall as well as rise.  You may get back less than the amount invested.

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