When financial markets teeter, as they have since 2022 began, there’s no shortage of speculation about where they are headed. Morgan Stanley warned recently that March could be a brutal month for stocks. One financial adviser echoed that sentiment, telling Bloomberg News that “there will be a lot of volatility in the markets” and “lots of chances to put cash to work at attractive levels.” The collapse of Silicon Valley Bank has further fueled speculation about interest rates, bank stocks and the impact on broader markets.
The problem is no one has any clue what markets will do in the near term. But nothing grabs investors’ attention like a shaky market and an old-fashioned bank run, giving financial firms and the commentariat an opportunity to peddle their products and broaden their fame, mostly by sowing fear of declining markets and looming financial crises. And why not? Once the hysteria fades, no one remembers who said what anyway.
The chatter would be entertaining if it weren’t so costly. Too many investors act on the unreliable predictions they hear, often by selling their investments and hiding in cash until the talk dies down, eventually buying back the same investment at a price higher than the one at which they sold it.
The S&P Regional Banks Select Industry Index, a collection of about 140 regional banks, tumbled 30% from its February peak through Monday, more than two-thirds of the decline coming in the last three trading days on news of SVB’s collapse. The SPDR S&P Regional Banking ETF, a fund that tracks S&P’s index, experienced a surge in trading volume during those three days, presumably because investors scrambled to dump their shares. Watch them buy back those same shares after prices recover.
That’s what investors do routinely. Morningstar’s latest Mind the Gap report finds that investors earned about 1.7 percentage points less than the total returns their fund investments generated over 10 years through 2021. The gap, Morningstar finds, “stems from poorly timed purchases and sales of fund shares, which cost investors nearly one-sixth the return they would have earned if they had simply bought and held.”
So it’s a particularly good time to remind investors that the most reliable way to grow their money is to invest in a low-cost, broadly diversified portfolio, ignore predictions and hang on through the inevitable ups and downs.
The investing part is easier than it sounds. The first step is to strike a balance between stocks and bonds. Almost everyone will want both stocks and bonds in their portfolio, the stocks for growth and the bonds for stability. In general, the more stocks, the higher the expected return and volatility, and inversely, the more bonds, the lower the expected return and volatility.
The historical record is instructive. In the table below, I show the annualized total return for a variety of stock/bond portfolios using the historical performance of the S&P 500 Index and long-term US government bonds back to 1926. I also estimate, based on stocks and bonds’ historical volatility, how much the portfolios are likely to decline in a panic like the 2008 financial crisis or the onset of Covid-19. (For finance geeks, the drawdowns represent a three-sigma deviation from the mean return using the annualized standard deviation of monthly total returns.)
A few things to note. First, the drawdowns indicate volatility, not permanent loss. US markets have always recovered after declines and moved on to new highs. There’s no reason to think that a broadly diversified portfolio, including a globally diversified one, will behave differently going forward. Still, volatility should be taken seriously. The greater the drawdown, the greater the danger of selling in a panic and locking in losses. Bigger drawdowns also result in deeper losses if investors need to pull money from their portfolio in a downturn.
Second, the historical record is more useful for gauging the trade-off between return and volatility than as a precise measure of future return and volatility. That’s not to say the historical numbers have no predictive power. In fact, when looking at older US data or numbers from around the world, the results are roughly the same. With some variation, long-term investors are likely to achieve results similar to those in the historical record. But whatever the result, a higher return will almost always come at the cost of deeper drawdowns.
Third, investment returns are more modest than generally acknowledged, particularly after inflation, which is likely to erode them by 2% to 3% a year over the long term. The dirty secret of finance, despite all the bravado to the contrary, is that money grows slowly. Institutional investors, such as pensions and endowments, generally grow their money at about 7% to 8% a year before inflation, in line with a balanced portfolio of stocks and bonds. In my experience, investors rarely do better and more often do worse, as Morningstar cautions. But even a modest 7% return can have a big impact over time, multiplying money more than 12 times over 50 years after inflation.
The trick is to start early. There are many low-cost exchange-traded funds that track broad baskets of stocks and bonds. Once you have yours picked out, along with your preferred stock-bond allocation, don’t wait to get started. It’s tempting to put off investing, to rationalize that there will be a better time to buy, particularly with all the scary talk about markets right now. On the contrary, the best time to buy is during a downturn, when everything is on sale.
In an ideal world, financial pundits would encourage people to invest regularly and remain invested. But let’s face it, smart investing is boring, and boring doesn’t sell. So don’t expect the yapping to go away; just learn to ignore it.
Nir Kaissar is a Bloomberg Opinion columnist covering markets. He is the founder of Unison Advisors, an asset management firm.