When it comes to successful investing, investor behavior trumps everything else. You can have the most optimal portfolio ever designed, but if you can’t stay invested in that portfolio, it doesn’t matter. Unfortunately, most investors sabotage their investment portfolios with their own bad behavior. Bad behavior takes many forms, but it always has one common theme: the investor didn’t stay invested.
If you’re going to be a successful investor, you must stay invested. This sounds simple, but it’s not easy. There will be periods of time that stir up emotions and create a strong desire to change your portfolio. The key to staying invested through challenging periods is maintaining appropriate expectations. If you know what to expect, you can avoid surprises and you’ll be less prone to making emotional decisions that sabotage your investment results.
So, what should you expect when you’re investing?
As a stock investor, you must be prepared to see your account balance drop. Market declines are an inevitable part of investing and they happen on a regular, although unpredictable, basis. In fact, almost every year contains a “correction” (defined as a decline of 10% or more). Most people don’t get too bothered by these corrections, it’s usually “bear markets” that cause problems. Bear markets are defined as declines of greater than 20%, but they have averaged closer to 30%. Historically speaking, they have come along about every 5 years.
Keep in mind, declines can happen more or less frequently, and the magnitude of the declines can be larger than the averages. Investors in the early 2000’s saw the S&P 500 Index get cut in half twice! The first decline happened between 2000-2002 and the second happened in 2008-2009. Declines of this magnitude are less common, but they do happen, and you must be mentally prepared for them.
It’s tempting to try to predict market declines and “get out” before they happen, but this is a fool’s errand that almost always results in a poor investment experience. Despite what some people claim, it’s nearly impossible to predict declines with consistency, so the only option is to stay invested until things turn around. Unfortunately, most investors panic when they see their account balance drop, so they sell their investments, and miss the eventual recovery. But, if you can keep your head when everyone else is panicking, you can participate in these recoveries and earn the long term returns of the stock market.
Seeing the money you worked years to accumulate seemingly disappear is frightening and it’s no surprise that market declines cause many people sell out of their investments. But, if you know that declines of this magnitude are normal, and you have faith that things will get better at some point in the future, you’re much less likely to panic and sell.
Although the market has a positive expected return over long time horizons, investors need to expect extended periods of little to no growth in their portfolio. The most recent example is what pundits label “the lost decade,” which represents the period between January 1, 2000 and December 31st, 2009.
As you can see below, a dollar invested in the S&P 500 at the beginning of that time would be worth 91 cents at the end. To be sure, this is an extreme example using only one asset class. The chart also shows that a globally diversified portfolio fared better during this period, but the principle still holds: there are going to be extended periods where your account balance doesn’t grow.
Extended periods of little to no growth can make you feel that your portfolio is defective and creates the desire to change something. Usually, this means abandoning your diversified portfolio to invest in whatever asset class has been performing well recently. I call this “performance chasing” and it is often the start of a vicious cycle of buying high and selling low.
The key to avoiding this trap is understanding that periods with little growth are inevitable and completely normal. With that understanding, you’ll realize that your portfolio isn’t defective and the impulse to make changes will be reduced. With your emotions under control, it comes down to being patient enough to sit through these frustrating flat periods.
If you turn on CNBC to see what “the market” did, you’re probably looking at the values of the Dow Jones Industrial Average (DJIA) or the Standard & Poor’s 500 Index (S&P 500). For whatever reason, most investors use these as benchmarks for their portfolio. But, if you’re a truly diversified investor, this is an apples-to-oranges comparison. The DJIA and S&P 500 represent one asset class: large companies in the United States. A thoroughly diversified stock portfolio will also include medium and small companies, international companies, and potentially publicly traded real estate (REIT’s). If your portfolio includes multiple asset classes, I can promise you one thing: your portfolio will perform differently than the benchmarks you see on TV. Sometimes you will do better and sometimes you will do worse.
The chart below depicts the difference in return between a globally diversified equity portfolio (represented by Dimensional Equity Balanced Strategy Index) and the S&P 500 from 1970 to 2017. You can see that the S&P 500 did better than the global portfolio 19 times and worse 29 times. Don’t take this as me saying that a global portfolio is necessarily going to do better in the future – the key takeaway is that the returns are going to be different and that means sometimes you’re going to underperform the S&P 500 or any other commonly used benchmark.
Look at the period from 1995 – 2000. During that time, the S&P 500 outperformed the global portfolio for 5 years straight, leading many people to switch out of their diversified portfolio to concentrate their portfolio in large US company stocks (particularly tech stocks). They did this just before things switched and the global portfolio trounced the S&P 500 for the next 7 years.
Periods of underperforming common benchmarks can be difficult psychologically. They can make you doubt your initial asset allocation decisions and lead you to change your portfolio based on the recent past, something that is never advisable. If you understand that your portfolio is different than commonly used benchmarks and accept that periods of underperformance are inevitable, you’ll be much less likely to second-guess yourself and make ill-advised changes to your portfolio.
Before I scare you away from investing altogether, let’s talk about the positive expectations involved in investing. If you control your emotions and stay invested through the difficult periods I’ve just described, you can expect to grow your wealth substantially over time.
The chart below depicts the growth of $1 invested in a few different asset classes. It’s pretty astounding isn’t it?
All you have to do to participate in this growth is stay invested. Again, this is simple, but it’s not easy. Terrifying bear markets, exhausting periods of “going nowhere”, and periods of underperforming less diversified benchmarks wear on the emotions of even the most disciplined investors. Unfortunately, this leads many investors to sell out of their investments at the worst possible time causing them to miss the incredible returns the market has to offer.
The key to avoiding this trap is maintaining appropriate expectations. When you know these periods are normal and expect them to come along throughout your life, they have less emotional impact. When your emotions are in check, it’s a lot easier to stay invested, and staying invested is the foundation of investment success.