Why you should stay invested
The next time you think it's a good idea to get in and out of the market based on some vague notion that you can predict ups and downs, remember this line, which came from investing great Jeff Gundlach during a presentation recently:
"In risk assets, you make 80 per cent of your money 20 per cent of the time."
Smart investing is not complicated, but it can be terribly difficult. The single biggest reason why most investors fail is simple and widespread: Money flows in and out of assets at exactly the wrong time - in, just when things are expensive, and out, just as they're cheap.
One 2007 study found that US mutual fund investors earned an actual annual return of 1.6 per cent below their funds' stated performance from 1991 to 2004 due to buying high and selling low. Compounded over the course of a lifetime, that can literally be the difference between retirement and no retirement – especially when you consider other research that shows managed funds tend to underperform the index itself. That’s a double blow.
It happens over and over again. And it will keep happening in the future. Unless you understand Gundlach's advice, you'll probably fall for it as well.
The rational choice
Stocks outperform most assets over the long run. Most agree on that, and history is pretty clear on setting the record. Ideally - and rationally - anyone with more than 10 years to invest would buy stocks at good prices and forget about it. You know you're in the right asset for the long haul. So why fret and bother second-guessing, tweaking your portfolio between other assets?
Part of the reason investors second-guess stocks is due to how returns have been marketed. Started by academics and run with by Wall Street marketing geniuses, the concept investors have been told time and time again is that US stocks return something like 7 to 9 per cent a year over the long run - better than any other asset class. And that's true. They have.
But that can be misinterpreted to imply that US stocks return 7 to 9 per cent every year. And folks, they emphatically do not. While the long-term average annual return works out to 7 to 9 per cent a year, what happens in between is wild and chaotic.
In fact, stocks spend more years down more than 20 per cent or up more than 20 per cent than they do within the 7 to 9 per cent range.
There have been about 21,000 trading sessions between 1928 and today. During that time, the US Dow Jones index went from 240 to 13,000, or an average annual growth rate of 5 per cent (this doesn't include dividends).
If you missed just 20 of the best days during that period, annual returns fall to 2.6 per cent. In other words, half of the compounded gains took place during 0.09 per cent of days. That's a more detailed version of Gundlach's wisdom.
Now, every time that stat is used, someone says, "Sure, but what if you missed the worst 20 days?" Indeed, if you missed the 20 worst trading days since 1928, average annual returns jump to over 7 per cent (before dividends).
The good and the bad
But what's interesting about those 20 worst days? Most happened at nearly the same time as the best 20 days - 1933, 1982, 2002, and 2008. It's implausible to think anyone could have avoided the worst days and hit the best days without simply being lucky. It can literally mean in Monday, out Tuesday, back in Wednesday.
Most of us at The Motley Fool think that the best way to build wealth is to buy good companies at good prices and hold them for a long time. Staying invested, in other words. That could mean having to endure a few years - sometimes several years - of really bad performance.
That's OK. It happens. It's a perfectly normal of part of stocks' long-term superior performance, as counterintuitive as it seems. "Volatility scares enough people out of the market to generate superior returns for those who stay in," Wharton professor Jeremy Siegel said last year.
The exception isn’t the rule
What we're not into is thinking we can time the market - get in now, get out now, "I'm expecting a weak second quarter," that sort of stuff. The number of people who can do that consistently and profitably is a rounding error compared with the numbers who try it and end up burned. Most will end up missing out on the 20 per cent of the time when 80 per cent of the profits are made.
There is a place for bonds, cash, gold and other assets, of course. If you're nearing retirement, or need to access your money at some point over the next decade, being 100 per cent in stocks doesn't make sense (unless you’re fortunate enough to be able to live on the dividends alone).
If you don't have an appetite for ups and downs (and many don't), don't even try stocks in the first place. And sometimes valuations make so little sense - like 1999-2000 - that selling stocks makes sense for long-term investors based on valuations (but not market timing).
But for most investors most of the time, the surest way to build wealth is to be invested, stay invested, and not get scared out because of temporary fears. Many will ignore or forget that advice. And most of them will end up poorer than if they had not. It's happened in the past, and it will happen in the future.
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Morgan Housel is a Motley Fool contributor. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).