The Biggest Mistake
Key Takeaways
There are consistent ways in which people fail in investing; it’s usually a case of either selling in a panic, or failing to invest due to fear.
Selling in a panic locks in your losses, realising them on paper and prevents you from benefitting from market recovery.
Market crashes while scary, are almost always temporary. In fact, investing when prices are depressed can help further boost your long-term returns.
The good news is by diversifying your investments, you don’t need to back a winning horse to reap returns. It also helps to reduce losses during drawdowns by spreading out your risk and exposure to multiple sectors and industries.
Understanding your portfolio, its asset allocation, and the possible outcomes gives you the best chance to have a positive investment result.
Fear incites human action far more urgently than does the impressive weight of historical evidence.
Many investors start investing as a way to grow wealth and preserve purchasing power over the long term.
There are quite a number of ways to be successful as an investor — such as investing in smaller but riskier companies (small companies), in companies which have temporarily depressed prices (value companies), and companies which exhibit longer term profitability metrics. These are academically proven ways to increase returns.
However it’s almost always the same reason when people fail in investing and lose big sums of their hard earned money. It’s typically a result of chasing fads or letting emotions overcome logic — e.g selling in a panic or failing to invest because the environment seems scary.
Market crashes can be scary for even the most experienced investors and even the best in the business make mistakes (Warren Buffett: ‘Tesco was a huge mistake’). When the stock market experiences a significant decline over a short period of time, it usually results in panic and fear among investors, triggering their flight or fight response.
When prices keep going down with no end in sight, it is very tempting to sell your investments and flee to avoid further losses. But this is often the worst thing you can do.
Selling Locks in Your Losses
When you sell during a market downturn, you lock in your losses. This means that not only are you making the losses on your investments come true, but you're also missing out on the potential gains when the market recovers. A recent WSJ article on retirement in the US featured a number of retirees who are living off less than $1M in assets and how they get by.
A particular segment in the story was agonising yet familiar to read;
Mr. Jones’s retirement account took a hit in 2008 and never recovered. Spooked by the S&P 500’s -38.49% decline in 2008, he sold his stocks and invested in a stable value fund that earned about 1% a year, said the couple’s son-in-law, Jon Older, a doctor who has managed the portfolio since 2018.
Imagine losing around -40% in value in your investments, and then rotating out into something that gives you 1% a year. It would take you over 65 years just to breakeven. What hurts the most is that the S&P 500 is up a cumulative +640% (in USD terms) since the 2009 bottom — gains he would’ve made if he still held those stocks.
Bear Markets are Temporary
While market crashes can be scary, they're almost always temporary. Historically, the stock market has always bounced back from crashes, often times stronger than before. By holding onto your investments through a sell-off, you give them the chance to recover along with the market. What’s more, if you managed to add more capital when prices are depressed, you boost your long-term returns even more. The chart below shows the differences in duration and the numerical gains (or losses) from investing in global stocks over the years.
Diversification is Key
One of the best ways to protect yourself from suffering more than expected during market drawdowns is to diversify your portfolio. By investing broadly across all available stocks and different sectors, you can spread your risk and reduce your exposure to any one company or industry. This means that if one stock or sector experiences a significant decline, it won't have as big of an impact on your overall portfolio. The diagram below shows how increasing your holdings and being more broadly diversified removes unsystematic risk away from your investments.
When you include other assets such as bonds in your portfolio, you increase diversification even further — although it reduces risk at the expense of returns. However, there are also periods when this type of asset allocation does not help so much, such as last year in 2022, when both stocks and bonds suffered double digit losses.
Market sell-offs and bear markets can be scary, but selling your investments in a panic is the worst thing you can do as an investor. By having a proper investment plan, having a good handle on and understanding of your portfolio, its asset allocation, and the possible outcomes (both good and bad), you give yourself the best chance to weather the storm and come out ahead in the long run.
If you have worries about what could happen during this type of environment, are unsure of what to do now, or need a trusted second opinion on your investment holdings, come and chat with us.
