RELEARNING OLD TRUTHS IN A NEW WORLD
We once had a client who ignored our advice and exited the market during a rough patch like the one we’re experiencing now. She decided to wait on the sidelines till things calmed down. Several years later, she was still waiting for that “perfect opportunity” to get back into the market. As a result, she missed three years of strong S&P 500 returns: 31.5%, 18.4%, and 28.7%. A costly mistake.
People who don’t have much personal experience with investing and financial decision-making tend to make some common mistakes. One of them is trying to predict the optimal time to buy or sell stocks.
Often that mistake starts when an inexperienced investor gets lucky. For example, the investor buys a stock which skyrockets a few weeks later, or sells a stock which crashes a few weeks later.
Random fluctuations in markets happen all the time. Sometimes you get lucky and manage to ride an investment that’s on its way up; other times, you get lucky and jump out of the investment just before it heads down. But inexperienced investors don’t understand how much short-term randomness there is in the market. As a result, when they get lucky, they don’t attribute that success to luck; they attribute it instead to something else, such as stock picking skill or intelligence.
Psychologists have a name for the tendency to attribute lucky successes to something other than luck: hindsight bias. Past events seem less random to people in hindsight. When an inexperienced investor gets lucky, they craft a story about their good fortune that makes it seem as though their skill or insight made that success inevitable. This story gives them a sense of false confidence. They start making judgments like, “This investment is going to go up in the next 6 months. I better buy now,” or, “This investment is going to go down in the next 6 months, I better sell now.”
In other words, they start feeling as though they have the power to predict the future. Feeling as though you have that power is what inspires the common mistake of trying to find the optimal time to enter or exit the market.
The problem is: predicting the future is impossible! That’s why crystal balls don’t work. It’s why people lose at poker and roulette. It’s also why no one can predict the optimal time to enter or exit the stock market. These are old truths, but when the world around us looks different, we tend to forget them.
Market history provides an antidote to trying to predict the future. It shows three things:
(1) it’s impossible to predict how markets will perform in the short term;
(2) there are long-term market patterns that tend to repeat themselves; and
(3) if you stay invested over the long term, your investments will achieve positive results, but you can’t achieve long-term positive results without experiencing short-term negative downturns along the way.
Here’s a graph depicting the Growth Of Wealth from 1980-2021. This provides a “zoomed out” perspective of the stock market over several decades. As you can see, the graph has a steep positive slope over time with only a few minor blips. $1 invested at the beginning of 1980 would have grown to over $132 by the end of 2021.
Graph 2 “zooms in” on 2018—one of the small blips in Graph 1. 2018 is barely noticeable on the longer-term graph, but when we “zoom in” we see that the market was up, then down, then up again before turning sharply negative to finish the year.
Comparing these two graphs illustrates an important point: the shorter the time frame, the less certain you can be about how the market is going to perform. Conversely, the longer the time frame, the more certain you can be about how the market is going to perform.
Since 1926 stock market returns have averaged roughly 10% per year. So, if you were planning on investing for 100 years, you could expect to earn on average 10% every year on that investment. But suppose we shrink the time frame. Suppose you want to invest for only 1 year. Now the result becomes much less certain. The stock market returns 10% per year on average, but that doesn’t mean that each and every year yields a 10% return. Single year returns have been as high as 54% or as low as – 43%. And if we shrink the time frame yet further to, say, a daily level, the result becomes even less certain. In fact, on a daily level, market ups and downs are almost completely random: about 53% of the trading days are positive. So, trying to predict the daily movement of the market is like trying to predict the outcome of a coin toss.
Understanding how markets work suggests a different approach to investing with 3 steps:
- Establish your long-term financial goals. Separate your financial goals by timeframes. Start with three and five year goals, then expand to 10 and 20 year goals. For example, in the three- to five-year timeframe, you might have goals like buying a car or saving money for a down payment on a house. In the 10-year timeframe, you might have goals like saving for a child’s college education. And in the 20-year timeframe, you might have goals like retiring with 80% or more of your current income level.
- Invest to achieve that goal. You need to ensure your investments continue to move toward your long-term goals. That means that over time, you need to re-balance your portfolio from time to time to anticipate both upward and downward market cycles. For example, if you’re planning on retiring in 20 years, you need to start drawing on your investments for income starting at that time. But it doesn’t end there. You need to ensure that your money keeps up with living cost increases for the remainder of your life. As a result, you need to continue re-balancing your portfolio on a regular basis to meet that longer-term goal.
- Wait! Tom Petty had it right: the waiting is the hardest part. If you’re investing to achieve long-term goals, you can’t react to short-term ups and downs in the market. That means that you need the patience to stay invested over the long term, and you need the ability to resist distractions such as the media, other people, and your own emotions.
For many investors, patience is a new skill they need to acquire. It used to be the case that people’s daily experiences cultivated patience. For instance, you’d order something from a catalog, and you’d have to wait a week or two for it to get to your door. These days, services like Amazon have trained people to expect things immediately. As a result, opportunities to learn patience have become increasingly rare.
Yet patience is essential for long-term success. Think, by analogy, of health. Acute health conditions can sometimes be treated with a procedure or a pill. But not all health conditions are like this. Overall health depends on cultivating new habits that maintain well-being over the long- term, like eating well and exercising regularly. The same is true of becoming a successful investor: doing well over the long- term depends on cultivating habits like patience and the ability to filter out sources of distraction that impede your ability to wait.
What are those sources of distraction? Here are three of them:
- The media: The media encourages the predictive mindset I talked about earlier. They feature one commentator after another speculating about what’s going to happen in the financial markets today or tomorrow. If you’re an inexperienced investor, you might think that these so-called experts are demonstrating how investing is supposed to be done. But they’re not. Typically, these so-called experts aren’t actually experts. They’re instead representatives of an industry that aims at increasing revenue by securing your attention. Media companies don’t aim to communicate information that will help you make better financial decisions. Instead, they’re focused on promoting a particular point of view so that they can secure more money from advertisers. As a result, what you hear from the media can distract you from achieving your long-term goals.
- Other people: Humans are social creatures. We are susceptible to social pressure. We’re prone to jumping on bandwagons, and prone to feeling afraid we’ll miss out on something big. But your financial circumstances, goals, and timeline are unique. What’s likely to benefit someone else is unlikely to benefit you. If you take cues from other people, you risk doing something that doesn’t promote your own long-term financial interests. As a result, what other people say about their financial situation can distract you from achieving your own long-term goals.
- Emotions: Emotions are notoriously bad guides to investment decisions. Emotions evolved as rapid responses to immediate environmental threats and opportunities. They weren’t meant to help us with long-term planning. Yet long-term planning is precisely what you need if you’re going to secure long-term financial well-being. Emotions are powerful forces that can distract you from achieving your long-term goals.
Long-term market history serves as a good guide for your investment decision-making. You should rely on that history to inform your financial decision-making, particularly when you lack personal financial decision-making experience. Start there. Ready for a real conversation?