The short term mistakes of a long term investor

Global financial markets have become progressively short sighted, spurred on by ever-increasing access to real-time data and technological innovation – according to Robert Kissell in 2020, 92% of all equity market volume in 2019 was comprised of algorithmic trading [1]. We no longer live in a world in which tomorrow morning’s newspaper is the first opportunity to catch up on the latest happenings in markets – all data is available 24/7 at the click of a button. Whilst a firm grasp of current machinations in markets is often useful for active investors, too much of a fixation on short-term data and trends, and the subsequent risk of short-term capital loss, can lead long-term investors to forget why they invested in the first place.

The following chart illustrates the dispersion of possible returns if one were to have invested in the MSCI World Index for various periods since 1975. The maximum possible 1-year return, if investing at the best possible time and selling exactly 1 year later would have been 67.9%. However, if one were to invest at the worst possible moment, and sell 1 year later, they would have lost 32.1% of their money. The chances of choosing the perfect moment to invest on a 1-year time horizon over 38 years are extremely unlikely, whilst the risk of such a significant downside move should one get it wrong over a 1-year period is extremely daunting. Interestingly, the average return of the MSCI World is somewhere between 9% and 12% per year between 1975 and 2023, as depicted by the light blue lines below. However, the dispersion of possible returns around this average shrinks markedly as we extend our time horizon. If investing for 20 years, even if you were unlucky enough to pick the worst entry and exit point, the lowest possible return would have been 4.53% p.a. – which equates to a cumulative +142.56% total return. If one does have a long-time horizon, the fundamental driver of returns is not timing the market, but simply being invested, and staying invested, for as long as possible.

*Data sourced from FE Analytics/MSCI [6]

The possible negative returns over shorter periods shown above plainly evidence the risks of large falls in equity markets. Significant falls in financial markets are common for a variety of reasons; asset prices regularly deviate from their ‘intrinsic value’ (that which the market is trying to ascertain) and can remain that way for a significant amount of time before correcting. A ‘bear market’ is defined as a fall in equity markets of more than 20%. Since 1945, there have been 15 bear markets – roughly one every 5 years. A fall of more than 10% but less than 20% is known as a ‘market correction’ and is much more common than bear markets. Such falls in equity markets are rightly scary for investors, as the thought of losing such a significant proportion of your money in such a short amount of time is gut-wrenching.

However, markets historically tend to rebound extremely sharply from such a significant fall. It is not simply the ability to predict a market downturn that allows one to successfully navigate such an event, as once investments are sold, the decision then needs to be made as to when to reinvest. The point at which markets bottom following a significant fall tends to be those moments where investor sentiment and news flow are at their most negative, and thus the point at which investors are least likely to want to buy back in. On 19^th March 2020, the front page of the FT read “Fear grips markets as faith in government intervention runs out” – the FTSE 100 and S&P indices bottomed just days later on the 23^rd [7]. To successfully time the market, investors must both predict a market fall and then buy back in at the hardest possible moment psychologically (as both levels of risk aversion and market volatility are heightened). Remaining invested throughout a market correction or bear market and avoiding the psychological pitfalls of trying to time the market, is by far the easiest way to avoid missing out on any potential future upside returns. Bear markets don’t last forever, and when they do end, they become bull markets, so selling to cash during a bear market raises the risk of missing out on significant returns once the market has bottomed.

The below chart depicts calendar returns for the MSCI World in each calendar year since 1976, alongside the lowest point during that calendar year period. The first important point to note is that in 77% of calendar years, investors received a positive return – further highlighting the long-term upward-trending nature of markets. The second important point to note is the difference between calendar year returns and the maximum loss during that calendar year. There are several years in which returns are significantly positive, yet the maximum drawdown is significantly negative, most notably in 2020 (-16% to +12%) and 2009 (-17% to +16%). This supports the argument that markets often rebound quickly following a significant downturn, making it extremely hard to time, and further demonstrating that remaining invested throughout is by far the safest option.

*Data sourced from FE Analytics/MSCI

Of course, many may not have a 20+ year time horizon or may have various buckets of investments with varying time horizons. Public and private equity markets historically have a higher level of risk (volatility of returns), than government bond markets for example – investors have therefore been compensated for taking equity market risk over government bond market risk with a higher long run rate of return. There is a wide spectrum of markets offering a range of risk and return profiles. For investors with a shorter time horizon, risk-conscious multi-asset class investing can significantly help in limiting downside risks. It offers protection through diversification of asset classes, and a higher allocation to historically lower risk (or volatile) asset classes.

Financial markets are inherently cyclical, meaning they repeatedly go up and down, sometimes by significant margins, but it is imperative to remember that in the long term, despite their cyclical nature, they trend upwards. By being invested, and remaining invested, you are exposing yourself to that long-term upward trend and will eventually reap the rewards.