Why volatile markets separate true investors from the rest

Male looking stressed out in front of his laptop computer

There’s a saying among seasoned pilots that flying can best be described as long stretches of boredom punctuated by moments of sheer terror.

Many investors, reeling from the recent pullback in the US sharemarket that commenced on 5 February after the stellar returns of 2017,  would no doubt share these sentiments.

For newer investors who’ve never experienced a share market pullback of this size and speed, the recent movements must have been nerve-wrecking. Media headlines screaming “market rout”, “bloodbath” and “worst point decline in history” certainly didn’t help matters either, stoking fear in the investing public for the sake of clicks, views and readership.   

If you’ve just had your first experience of a sharemarket dip, welcome to the club. Grab a seat and catch your breath. It may be your first market correction but it will almost certainly not to be your last. All-time sharemarket highs followed by the occasional reversal are a feature, not a bug, of long-term investing.

Keeping your head while those around you don’t

If you’re going to be a successful investor, you’re going to have to sit on your hands while the market has the odd dummy spit from time to time.

The recent market turmoil might have pushed many new investors outside of their comfort zones, where moving to the ‘safety’ of cash seemed like the prudent course of action. But if your objective is to grow your wealth over the long-term, cashing out while waiting for the volatility to subside and markets to rise again could prove to be a very expensive exercise.

That’s because when volatility spikes in the sharemarket it tends to do so in both directions –  unusually large falls as well as days with unusually large gains. And when markets do start to recover, the biggest gains can often be in the initial phases of recovery. Missing those strong ‘rebound’ days while sitting in cash can make a significant difference to long-term return outcomes.

According to analysis conducted by global investment firm Russell Investments, missing just the 10 best trading days over a 22 year trading period, would have reduced your total return by more than a third.

Russell Investments looked at the daily returns of the Australian All Ordinaries Accumulation Index (with dividends reinvested) from May 1995 to July 2017.  $10,000 invested at the start and held for the entire 22-odd year period would have grown to almost $69,000 dollars.

As the chart below indicates, missing the 10 best trading days out of that entire period (which encompassed more than 5,600 trading days) reduced the end value by almost a third to $43,148. Missing the 40 best trading days (which is still fewer than 0.7% of all trading days) reduced the return to a paltry $16,458.

Source: Russell Investments Data and chart based on All Ordinaries Accumulation Index. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. This hypothetical example is for illustration only and is not intended to reflect the return of any actual investment. Investments do not typically grow at an even rate of return and may experience negative growth.

The lesson from the Russell Investments research could not be clearer; exiting the sharemarket when things get bumpy may provide some short-term emotional relief, but in the longer-term may take a much higher toll on your financial wellbeing.

Staying the course

Investing is difficult not because of the complexity involved, but because of the emotional toll it takes. When markets fall and we see our wealth erode before our eyes. our fight or flight response kicks in, priming us to dash for the exits and head for the psychological safety of cash.

Unfortunately, even if you do go to cash, risk won’t be completely eliminated unless you’re willing to relinquish any hope of a real return, net of inflation and taxes. As Howard Marks, billionaire investor and one of the world’s greatest investment minds, has noted:

“I want to point out that whereas risk control is indispensable, risk avoidance isn’t an appropriate goal. The reason is simple: risk avoidance usually goes hand-in-hand with return avoidance. While you shouldn’t expect to make money just for bearing risk, you also shouldn’t expect to make money without bearing risk.”

It is possible today for individual investors, through services like Clover.com.au, to gain all the benefits of global diversification at a cost once available only to institutional investors.

We’ve done the hard work of creating the tools to help you achieve your long-term wealth creation goals. Provided, of course, that you can keep a cool head while others around you are losing theirs during the inevitable, occasional, market reversal.  

Who is Harry?

Ask Harry

Harry is a Co-Founder of Clover with over 20 years of experience in wealth management where he advised individual, SMSF and institutional investors.

When not making personal finance easier and less intimidating for Aussies, Harry loves his weekend bike rides and spending time with his wife and son. He’s pretty much the finance-savvy uncle you never had.

Got a question for Harry? Send your question to media@clover.com.au