The first half of 2020 was not a walk in the park for investors. The 11-year bull market was stopped in its tracks: Prices of large US company shares showed the steepest decline in the shortest time in a century, while South African share prices plummeted in sympathy by some 35% in one month.
While Corona-riddled news headlines prefigured ‘the end of the world as we know it’, seasoned investors simply sat on their hands. How you behave, as an investor, in abnormal times is disproportionately important to your prospects of earning decent long-term returns. Emotional decisions will rarely benefit your savings.
Although the 2020 bear market was unfamiliarly driven by a pandemic, the three most instructive principles of investing have not changed:
Principle 1: Time in the market beats timing the market
We have seen the biggest one-day drop in the US stock market in history – and also the biggest one-day gain in history, all in the matter of a month.
The temptation to ‘time the market’ in such volatile times is always there; to try to enter or exit at exactly the right time. With the benefit of hindsight, the swings in share prices look inevitable – and hence forecastable.
The main problem with market timing is that your emotions lag the cycle. You exit the market too late, when your anxiety becomes unbearable. And by the time that your gloominess is replaced by optimism, the market had left you behind.
Had you for instance decided at the end of March to wait for ‘lockdown sentiment’ to dissipate before investing, you would have missed out on a recovery of around 40% in share prices in six weeks – a decision that will affect your investment returns for many years to come. The cost of just missing out on a few of the best days in markets can be devastating to your returns over time (see Chart).
Principle 2: Long-term investments should not be warehoused in cash
Uncertainty and volatility are the psychological price you pay for acceptable long-term returns.
The average return of the South African stock market over the 10 years to mid-2020 was around 10% per year (dividends excluded), while a money market account at one of South Africa’s big banks offered you an average return of about 6,3% per year over the same 10-year period. These two numbers may not look miles apart for a novice investor; just remember, our brain deceives us when it has to calculate compound returns over long periods.
To demonstrate: If you invested R100 in the broad South African stock market in June 2010, and just left it there and reinvested your dividends, your investment was worth around R320 in June 2020. If you invested another R100 at the same date, this time in a money market account, that investment was worth around R180 in June 2020, had you reinvested all the interest earned.
An investment in the bank, over time and after tax, will find it difficult to win the race against inflation – resulting in a permanent loss of buying power. The stock market can be erratic relative to a money-market experience – but long-term returns are what matters most.
Cash should only be expected to provide for short to medium term expenses and an emergency fund; it is a poor long-term investment choice.
Principle 3: Effective diversification is the cheapest way to hedge your bets
Historically, financial storms had always been followed by long periods of sunshine. Well-diversified investment portfolios shared in this revival.
A sound wealth preservation strategy is one that avoids over-concentration of investments, whether it is over-exposure to one country, one region, one industry, one asset type, or a single company. And ideally, the strategy should to some degree provide for the composition of uncorrelated asset classes. Big permanent investment losses can nearly always be traced back to an over-concentration of capital in one type of investment.
A well-diversified portfolio puts you in the company of an informed investment community, in a balanced and inexpensive way. It gives you exposure to a variety of regulated asset classes, reputable businesses, different currencies – in sensible proportions. It isn’t based on a specific view of the future, but on a strategy that provides as best as humanly possible for any potential future.
Do your best to hold yourself to these three principles as an investor. And remember that successful investors are net buyers of a spread of shares, in quality companies, through all times. This consistent, unemotional ‘drip-feeding’ – and patience – are their only secret. They tune out to the narrative of gloom in time of underperformance – and are quietly guided by the five most important words in investing: ‘This time is not different’.