“You don’t have to control your thoughts. You just have to stop letting them control you.” – Dan Millman
With the S&P 500 officially in bear market territory and other indices not far behind, it is natural to question how much worse the market environment could get. Headwinds such as rising interest rates, soaring inflation, recessionary fears and continued geopolitical risk in Ukraine have weighed heavily on investors. In his latest book, The Laws of Wealth, behavioural finance expert Daniel Crosby points out that humans have a natural tendency to imagine the worst possible outcome and remember only negative events – rarely do we make a list of all the good things that are happening. This is a mechanism we have developed to help protect ourselves against future harm, or so we think. He also points out that this fear is often exacerbated by “profiteers of peril,” the financial media being one of the main contributors. Unfortunately, this innate desire to safeguard our futures can sometimes cause us to make irrational decisions at inopportune times.
It is not uncommon for investors to try to exit markets in order to avoid catastrophe they have conjured in their heads and re-enter markets when it is deemed “safe.” Some may have even had previous success in doing so, a lucky outcome that is unlikely to continuously work in your favour. Crosby points out that poor market timing decisions have actually been a major cause of annual underperformance, to the tune of 6%, when comparing the average stock mutual fund investors’ track record to that of the S&P 500 over a 30-year period ending in 2013. The very thing intended to reduce harm actually did more damage over the long term.
So how does one protect themself from these intrusive and potentially costly thoughts? The key is to recognize that market corrections (10% drop in stock prices) and bear markets (20% drop in stock prices) are normal and regular occurrences over the average person’s investment time horizon that generally present significant opportunity to add value over the long term. By staying invested and taking a disciplined approach to exploiting the opportunities, investors can continue to compound their wealth over a long period of time despite experiencing major market swings. In fact, getting back into markets is generally harder than selling when times get tough as the fear of being wrong again overpowers rational thinking. History shows that markets tend to perform best when coming out from their lows. Too often investors sitting on the sidelines do not get the confidence to re-enter markets until markets have recovered to prior peak levels – thereby missing out on significant periods of outperformance. The chart below demonstrates the significant impact on long-term returns of missing out on even just a few of the best trading days over a 32-year period.
Source: Columbia Management Investment Advisers, LLC and Bloomberg as of 12/31/21
Emphasizing the importance of staying invested is not to diminish the current risks that are inherent in today’s market backdrop. Unfortunately, it is impossible to predict what will ultimately happen, but we can actively prepare for various scenarios. Preparation begins with assessing individual risk and return preferences. Time horizon must also be considered within the context of the market environment. Goals-based investing can play a significant role in helping one stay the course while mitigating the effects of major market anomalies.
For our balanced clients, we have been preparing portfolios for weaker returns over the foreseeable future, trimming equity allocations several times over the past year to more conservative levels. Among other things, our decisions were driven by relative yields, elevated valuations, and heightened macroeconomic risks. QV’s bond portfolio is now offering a handsome ~4.5% yield – a level we have not seen since the time leading up to the financial crisis of 2008. Further, our funds are broadly diversified across sectors and geographies, which should help blunt some of the volatility stocks could experience. Our portfolio management teams have been sharpening their pencils as they refine their buy lists for when equity valuations become more compelling. While things may very well get worse before they get better, this balanced approach should provide ballast to our clients’ portfolios, allowing them to remain invested and to be ready for the opportunities that may lay ahead.