Welcome to 2021 — a year in which we hope to put the bad juju of 2020 to rest. Most of us will remember 2020 for the coronavirus pandemic, which not only sickened millions of people and devastated some families, but also created havoc for the U.S. economy. According to a survey in People Magazine, 47 percent of American said they experienced a difficult year financially, and nearly three quarters pledged to be smarter about money in 2021.
Are you one of the many people who included a financial resolution or two in your plans for this year? If so, I hope you’ll bookmark this blog so you can refer to it throughout the year — because when market volatility happens, and it inevitably will at some point — you’ll want to remember these five short investing maxims to stay on track:
- It’s always different. One thing I hear frequently from clients during a down market is, “This time is different.” When news about COVID-19 sent the markets into freefall last March, even some money experts jumped on the bandwagon. But we only have to look at history to see that while the markets have experienced a number of major declines over the years, the subsequent years for US equity returns have been positive on average. The details of each crisis may be different (think Great Recession, world wars, pandemics, the Great Depression, the stock market crash of 1987, etc.) but generally, the markets have rewarded those who stayed the course.
- Uncertainty and returns are related. Wouldn’t it be great if you could get a guaranteed return on your investment? Well, you can — in a savings account at your bank. The key thing to remember here is risk. A savings account or a certificate of deposit at your local bank will pay interest, but because the risk to you is low, the interest rate is also low. The stock market works in a different way. When you invest in the market, you take on an amount of risk that is right for you, and in turn, you may be rewarded with higher returns. Dealing with the uncertainty of major events, such as COVID-19, is one reason why investors earn a return over time. If there were no uncertainty about the future, and no uncertainty about the impact of events on stock prices, why could investors earn more than they would with a traditional savings account? If you approach investing with a realistic and long-term view, it’s easier to apply discipline during a crisis and you are more likely to capture a higher return.
- Many investing questions are market timing questions. When a major event affects the stock market, people often wonder if they should be moving to cash or investing more. That means they are anticipating either a positive or negative return. We believe markets are efficient, move quickly and incorporate all available information, so by the time information related to the event is known by investors, prices have already adjusted. In addition, if you decide to exit the market after a major downturn, you then must decide when to return. Often, people either decide to reinvest after a rebound has already started, or exit after the decline has already progressed, which means they have already missed the opportunity to take advantage of the full recovery or avoid the loss. In making these types of decision, investors additionally don’t always realize that they could be exacerbating additional costs or potential tax implications, they are trading on emotion and may not have thought through all the consequences of their actions.
- Expected returns and realized returns can be very different. When we invest, we look at two types of returns. “Expected” returns represent the profit or loss that we can anticipate based on an asset classes’ history, or rate of return. However, expected returns are never guaranteed because we never know exactly what will happen during time periods in the market. The “realized” return is the actual amount an investment gained or lost over the holding period. Many factors can affect fund or stock performance, including supply and demand, corporate earnings, or major events, so even if the expected return is 10% based on historical performance, the actual, or realized return could be higher or lower.
- Logic + Evidence + Diversification + Long-Term Approach = Higher Expected Returns. If you remember only one of these maxims, I hope this is the one you’ll keep in mind. Our clients hear us talk about evidence-based investing a lot. What we mean is that we make decisions based on information we know to be factual, such as long-term market history, peer-reviewed academic evidence and practical application. (This infographic does a great job of explaining the difference between evidence-based investing and traditional active investing.) We also believe in diversifying portfolios to include different asset classes, small, large, value growth, U.S. and international developed and emerging markets and bonds. Because of its makeup, a diversified portfolio will never be the best or worst performing compared to its components. The purpose of diversifying is to reduce the more extreme returns, to rebalance and increase the reliability of outcomes, especially over the long term, which is the last factor in our equation to reach higher expected returns.
It’s hard to know what 2021 will bring in terms of market performance. The best we can do is set personal goals, understand our tolerance for risk and work to design a portfolio that can withstand the inevitable ups and downs that the markets experience from time to time. Our strategy then becomes the bedrock that supports future investing decisions, enabling us to stay the course and ignore the financial news headlines.
This year commit to remembering these five maxims whenever you’re tempted to stray from your plans. And if you have questions, we’re here to help. Best wishes for a happy and prosperous New Year.