In these times of good returns and all-time highs on stock markets, many investors start to ponder if they should sell and try to avoid the next downturn. After a strong run in global markets, it is only natural to have some concerns about where we are in the market cycle and when the next correction might happen.

The problem is, trying to time the markets is notoriously difficult and it leaves the investor open to the risk of missing out on good, long-term returns.

Successful investors do not worry too much about market timing – instead they decide on a long-term strategy (based on their investment goals and their tolerance for risk) and have the discipline to stick to that strategy. Sure, there will be volatility along the way and there will be periods of negative returns, but over the long-term, equity markets have provided very good returns to those prepared to take a disciplined approach to their investment strategy.

Missing out on the best performing investment periods

A major problem with trying to time the market is that, even the most analytical of investors will allow some behavioural factors get in the way of good decisions. They tend to sell too early and then fail to buy back into the market at the optimum time. This means they miss out on the best performing periods in the market and this can have a huge effect on returns.

For example, see the chart below; this shows a hypothetical investment of $100,000 in America’s S&P 500 index. If you had missed the best 5 days in the market since 1988, your investment would be worth $675,788 less (-35%) than if you had stayed fully invested for the whole period. If you had missed the best performing 25 days, the effect is very dramatic.

It’s a similar story in New Zealand on the NZX index (although we don’t have data going back as far, so it doesn’t look quite as dramatic).

Market declines are a part of life for investors

Everyone knows markets do not go up in a straight line – they move in cycles and significant declines are to be expected from time to time. It’s not possible to achieve good long-term returns without experiencing these declines.

The following chart shows the value of $100,000 invested in the S&P 500 since 1988 (orange line). The blue line shows the decline in value of invested capital during a drawdown period (a drawdown is the percentage fall from peak to trough) that the investor would have had to tolerate from time-to-time during that investment period.

The declines were painful at the time but this demonstrates that, over the long term they can be tolerated.

How to worry less about volatility

As explained above, downturns are a fact of life when investing and investors need to be able to tolerate volatility to achieve good long-term returns. However, that’s not to say investors should ignore the risks and jump in to any financial investment without thinking it through in the hope that all will work out over the long term. Steps can be taken to avoid mistakes, to make sensible investment decisions and mitigate the effects of volatile markets;

  • For example, investment in a passive, index tracking strategy might not be a good idea if you are concerned about the high valuation of a market.
  • Instead, investors should consider investing with an active fund manager with a good track record. A reputable active fund manager will employ strategies to preserve capital in times of volatility as well as take advantage of rising markets when times are good.
  • Drip feed funds into the market in tranches – this helps smooth out the effects of volatility (this is one of the main advantages of KiwiSaver schemes).
  • Diversify into different asset classes and avoid having too many eggs in one basket.
  • Remember to keep long term goals in mind. Don’t worry too much about short term movements and maintain a disciplined approach to your investment strategy.
  • Talk to a reputable financial adviser – those financial advisers offering a DIMS service (Discretionary Investment Management Service) will regularly review your asset mix and make tactical changes to allocations in accordance with changes in markets and global geo-political circumstances.