Four Ways to Fight Fear With Facts
You wouldn’t be human if you didn’t fear loss.
Nobel Prize-winning psychologist Daniel Kahneman demonstrated this with his loss-aversion theory, showing that people feel the pain of losing money more than they enjoy gains. As such, investors’ natural instinct is to flee the market when it starts to plummet, just as greed prompts us to jump back in when stocks are skyrocketing. Both can have negative impacts.
But smart investing can overcome the power of emotion by focusing on relevant research, solid data and proven strategies. Here are four key concepts that can help fight the urge to make emotional decisions in times of market turmoil.
Market declines and bear markets are inevitable, common occurrences and they don’t last forever. The Dow Jones Industrial Average has fallen at least 20 percent about every three and half years, according to data from 1900 to 2014.
While past results are not predictive of future results, each downturn has been followed by a recovery and a new market high. After hitting lows in August 1939 and September 1974, the S&P 500 came back strong, with average returns of more than 15% over the next 10 rolling 10-year periods, in both cases. The 57% stock-market drop during the 2008 financial crisis was followed by a full recovery in the S&P 500 in about four years, essentially making investors who stayed in whole.
Historically, investors who stay the course over the long run are rewarded. Even including downturns, the S&P 500’s mean return over all 10-year periods from 1927 to 2014 was 10.54%.
No one can accurately predict short-term market moves, and investors who sit on the sidelines risk losing out on periods of meaningful price appreciation that follow market downturns.
Every S&P 500 decline of 15% or more, from 1929 to the end of 2014, has been followed by a recovery. Returns in the first year after each market decline have averaged 54.78%.
Even missing out on just a few trading days can take a toll. A hypothetical investment of $10,000 in the S&P 500 made in 2002 – the start of the recovery following the bursting of the technology bubble – would have grown to more than $18,000 by the end of 2012. But if an investor missed the 10 best trading days during that period, he or she would have ended up with just $9,378 – less than the initial investment.
One way to avoid futile attempts to time the market is with dollar cost averaging, where a fixed amount of money is invested at regular intervals, regardless of market ups and downs. This approach creates a strategy in which more shares are purchased at lower prices and fewer shares are purchased at higher prices. Over time investors pay less, on average, per share.
Retirement plans, to which investors make automatic contributions with every paycheck are a prime example of dollar cost averaging.
As of December 2014, annualized investor returns over a 10-year period were higher than the typical published target date fund results, according to a Morningstar report, which used fund flows as part of the calculation for investor returns. The study showed that the annualized investor return over that 10-year period was 6.1%, 1.1 percentage points higher than the typical target date fund, because investors consistently contributed to their retirement target date funds.
“Target date investors have essentially reaped all of target date funds’ gains, plus more,” according to the Morningstar report. “That’s largely due to the discipline inherent in regularly setting aside a portion of each paycheck into retirement savings accounts — the predominant means of investing in these funds. In contrast, most broad investment categories, such as U.S. equity, international equity and taxable bond funds, have negative investor return gaps.”
While diversification doesn’t guarantee profits or provide assurances that investments won’t decline in value, it does lower risk. By spreading investments across a variety of asset classes, investors lower the probability of volatility in their portfolios. Overall returns won’t reach the highest highs of any single investment – but they won’t hit the lowest lows either.
A portfolio diversified in four asset classes had a higher return than the lowest returning asset class in any given year over the 20 calendar years through 2004, according to a Capital Group study.
For investors who want to avoid some of the stress of down markets, diversification can help lower volatility.
It’s natural for emotions to bubble up during periods of market volatility. Those investors who can tune out the news are better positioned to plot out a wise investment strategy.
Market declines are normal. Don’t give in to fear. History shows recoveries have followed downturns, and long-term investors have been rewarded.
Market timing backfires. Stay the course. Missing out on just a few trading days can take a painful toll on your portfolio.
Dollar-cost averaging can help. Invest regularly, even when the market is falling. Turn market downturns into buying opportunities.
Diversification matters. Diversify across sectors and regions in order to spread your risk and reduce overall volatility in your portfolio.