We Have Seen This Before
The graph above shows the performance of the U.S S&P500 Index from 1926 to the current day. The highlights are an average annual return of 10.1% and the growth of $1 to $10,716 over the 96-year period.
The bad news? Plenty of bumps along the way – though those bumps before 1980 are difficult to identify given the impact compounding returns has over time (and only those with great eyesight can identify the October 1987 crash - it is inconsequential now). Einstein told us compounding interest is the eighth wonder of the world, and he who understands it, earns it, and he who does not, pays it.
There is, and always will be, uncertainty in the outlook for the economy and financial markets. 2022 has not been a good year for financial markets – the S&P 500 is down around 20% since 1 January 2022, but at times has been down over 25%. Several events have contributed to this:
COVID disruptions to supply chains, leading to rising prices.
In the U.S, there are almost two jobs posted for every unemployed person, leading to wage pressure and further fuelling inflation.
Massive fiscal and monetary stimulus during the pandemic has led to high government debt levels, creating concerns about future economic growth.
Russia’s invasion of Ukraine disrupting energy and food supplies.
Government policies to discourage carbon-related energy production has impacted capacity, again creating inflationary pressures for energy.
Investors need to be mindful of the difference between risk and uncertainty. For example, when we roll dice, we can precisely calculate the odds of any outcome. We can calculate the risk of certain outcomes. Uncertainty exists when we cannot calculate the odds, like how the Ukraine situation will be resolved.
Investors often confuse the two concepts.
When economic conditions are good, many people consider investing in the stockmarket as risk, where the odds can be calculated precisely – “the S&P500 has returned 10.1% over the past 96 years, so I’ll probably get an average 10% each year for the next decade”. One’s ‘ability’ to estimate the odds leads to overconfidence, an all too human trait.
However, when inevitable unfavourable events occur, many investors’ perception of investing in the stockmarket shifts from one of risk to one of uncertainty. Think about early 2020 when the pandemic first hit – no one had any certainty over what would happen next. Many predicted, with confidence, house prices would fall substantially – in fact, the opposite happened.
Investors prefer risky bets to uncertain bets, so when markets begin to appear uncertain to investors, the risk premium they demand rises – and that causes stock prices to fall. (This former article explains the maths behind this: why-you’re-crazy-to-sell-when-shares-prices-fall).
When there is uncertainty, many investors do the opposite of what they should do – they sell out of equities. One recent study[i] found ‘ambiguity shocks’ led investors to trade more and trade out of risky securities. Around 60% of investors were likely to behave in this way.
Many people seek a level of guarantee when making investment decisions that is simply not achievable.
Investing in equities is always about uncertainty, not risk. In fact, this is why the equity risk premium (the additional return an investor requires for investing in the stockmarket versus lower risk assets like government bonds) has been so high since 1926 – investors demand a greater risk premium to compensate them for taking uncertain ‘bets’.
A major part of our role as financial advisers is to help clients understand how much equity risk they need to take to achieve their goals, and ensure this level of risk is within their capacity to absorb and endure unforeseen events.
We expect, and plan for, market falls.
When I talk to a client about to exit the workforce, I remind them that for the remainder of their life, they are likely to experience perhaps five or more occasions when their share portfolio falls by 20% or more – like we are experiencing in 2022. It is an inherent part of investing. Markets are unpredictable – but understanding this, and knowing your plan accounts for this reality, hopefully avoids the mistake of letting your stomach, rather than your head, make investment decisions.
Investors have demonstrated the unfortunate tendency to sell well after market declines have already occurred and buy well after rallies have long begun. The result is that they dramatically underperform the very funds in which they invest.
Research by Dalbar, a company that studies investor behaviour and analyses investor market returns, consistently shows that the average investor earns below-average returns[ii].
For the 20 years ending December 31, 2019, the S&P 500 Index averaged 6.06% per year (a below average period thanks to the 1999/00 tech crash and GFC). The average US equity fund investor earned a return of only 4.25%.
At the end of 20 years, the average investors portfolio was worth 30% less than if they’d just left their money invested in the market.
To quote Gene Fama Jr., a famed economist, “Your money is like a bar of soap. The more you handle it, the less you’ll have.”
It is a reminder that our role is not only to identify optimal investment products for our clients to invest in, but to ensure people remain invested when circumstances may encourage you to do otherwise. This is the real value of having a financial adviser in your corner.
We appreciate learning to be a good investor is hard. Many think it should be easy. There is plenty of information, decades of evidence and many willing teachers. Despite this it is anything but – we only need to look at the Dalbar results to acknowledge how tough it can be.
If we look at the evidence, we can see bad investment times never last forever. The graph below looks at the performance of a 60% growth asset portfolio over 1, 3 and 5 years following major uncertain events of the past 25 years. If you stay focused on the next 5 years instead of the next 5 weeks, you will find the experience of investing far more bearable.
Source: Dimensional
Author: Rick Walker
[i] Dimitrios Kostopoulos, Steffen Meyer and Charline Uhr, authors of the study Ambiguity and Investor Behavior, published in the July 2022 issue of the Journal of Financial Economics
[ii] Dalbar, Inc. "2020 QAIB Report."
Sources for this article:
https://www.evidenceinvestor.com/the-impact-of-uncertainty-on-investor-behaviour/
https://behaviouralinvestment.com/2022/09/20/learning-to-be-a-good-investor-is-hard/