There are always risks in the equity markets. To many readers, it may feel like risks are currently high and on the rise. But of all the risks that are increasingly grabbing people’s attention today – the trade war, impeachment, recession, etc. – none of them are actually the biggest risk to long-term investor returns, in my view.
I believe there’s an even bigger risk out there today, and it has nothing to do with economics, earnings, interest rates, trade wars, or market fundamentals. The factor that I think could hurt long-term returns the most – and thereby pose the greatest risk – is an investor’s attempt to time the market’s peak.
As recession talk continues in the current environment and the ‘wall of worry’ builds, more and more investors are likely to try and guess the top of the bull market. What concerns me today is that even the slightest whiff of downside volatility could trigger knee-jerk reactions for people to jump ship and sell stocks, which is almost always a bad decision. This risk of making a knee-jerk reaction is even higher in the modern era, where information moves very rapidly and negative headlines are easy to find.
For example, investors used to think about volatility in terms of years or even decades, but these days volatility is more commonly measured monthly or even daily! The problem with this mindset is that looking at volatility over short time frames often paints a picture of a choppy and scary stock market. When conditions appear uncertain, investors are more prone to make timing decisions instead of sticking to a long-term strategy.
As usual, history provides some clarity. If we look at S&P 500 returns in rolling 1, 3, 5, and 10-year periods from 1871 through September 2019, we indeed find that volatility and the possibility of negative returns are more prevalent over short time frames. In one-year periods, volatility1 registered at 19% and the possibility of a negative return was 28%. But as you zoom out and look at longer time frames, volatility decreases as does the probability of a negative return. Take a look at these stats:2
- 1-year rolling period: volatility 19%, possibility of negative return 28%
- 3-year rolling period: volatility 10%, possibility of negative return 16%
- 5-year rolling period: volatility 8%, possibility of negative return 11%
- 10-year rolling period: volatility 5%, possibility of negative return 3%
That last data point deserves another look. If you held onto equities in any 10-year period from 1871 to September 2019, you had a 97% chance of achieving a positive return. It’s crucial to note, however, that these odds do not exist for the investor who tries to ‘time’ market peaks and troughs. The odds do apply to the patient, long-term focused investor who sticks to the plan and dodges gut reactions, in my view.
Bottom Line for Investors
I believe the key to managing this ‘biggest risk’ is: remember that stock prices eventually align with fundamentals. Over the short term, stock prices will fluctuate far more often than a company’s fundamentals will. There will be times when a stock’s price trades far above its actual value, and times when a stock’s price trades far below where it should. But over the long term, the stock market is a ‘weighing machine,’ reflecting the value being created across the global economy. If you believe the global economy will be bigger, more diverse, and wealthier overall than it is today – which we do – then short-term fluctuations should never affect your decision-making.
As recession talk increases in the months and quarters ahead, and as economic conditions seemingly become more uncertain, the temptation to try and time the bull market’s peak is likely to rise as well. Any downside volatility will be hard to ignore, and investors may misconstrue normal selling pressure for a full-blown bear market. Try to avoid getting caught in this trap.