Everr wonder why the average investor doesn’t match the index returns? How can individuals consistently underperform their own investments? The answer is simple: They behave incorrectly during periods of market volatility and succumb to the classic mistake of selling low and buying high. For example, during the past few weeks, stock markets have been down worldwide, with much nattering about slow growth in China, faltering emerging markets and low commodity prices. The media headlines and lead paragraphs practically make you sick to your stomach.
Let’s try another explanation. What if stock prices were just overdue for a correction and history shows these events are ordinary? We haven’t had even a 10-percent correction for four years. For the S&P 500, the average intrayear decline, according to J.P. Morgan, is 14.2 percent during the past 35 years, even though 27 of those 35 years finished in the plus column. It could be that 1,419 days without a correction might cause investors to overreact, and hinder their long-term goals. Investors who sold out in the panic of 2008-09 did permanent damage to their financial plans. Many have not recovered, even though evidence suggests we have experienced strong equity markets since the spring of 2009.
Here is my point: Anything that suppresses volatility, such as owning less volatile bonds and cash, suppresses overall return. Higher returns are the reward for enduring higher volatility. Most Americans are grossly under-saved anyway, and those higher returns make it easier to attain your financial goals — and you might have a chance of beating inflation and not outliving your money. If your cash pile is large enough, you can invest at the risk-free rate, currently near zero, and experience no volatility.
Most of us are not that fortunate. We need some risk on a portion of the assets that earn a higher return. Without it, the chance of achieving our life goals (education, dignified retirement, charity, family legacy) is diminished.
“Buying the dips,” otherwise known as dollar cost averaging, is a good strategy in response to short-lived downturns in financial markets. Rebalancing to established target asset allocations during market downturns is a good way to “buy the dips” — many of you are doing this already with your 401K. You can rebalance by adding cash, or trimming one asset class and adding to another. It’s simple stuff, but it’s hard to muster enough courage when the breathless talking heads offer confusing, even conflicting, advice.
As a general rule, we never sell out in response to garden variety fluctuations in stock values. It’s expensive and often results in trading costs and taxes. It also complicates matters by creating the problem of when to get back in. Finally, it kills long-term performance by missing the frequent “equal and opposite reaction” on the upside that often accompanies downside volatility.
So let’s recognize volatile, long-term assets with higher average returns for what they are — one component of a properly diversified portfolio that contributes to overall return.