3 key investors principles to consider
3 key investors principles to consider
The Sandbox Daily (2.12.2024)
Welcome, Sandbox friends.
Today’s Daily discusses:
3 key investor principles to consider
Let’s dig in.
Markets in review
EQUITIES: Russell 2000 +1.75% | Dow +0.33% | S&P 500 -0.09% | Nasdaq 100 -0.44%
FIXED INCOME: Barclays Agg Bond +0.02% | High Yield -0.22% | 2yr UST 4.478% | 10yr UST 4.179%
COMMODITIES: Brent Crude -0.23% to $82.01/barrel. Gold -0.25% to $2,033.6/oz.
BITCOIN: +4.09% to $50,064
US DOLLAR INDEX: +0.04% to 104.149
CBOE EQUITY PUT/CALL RATIO: 0.48
VIX: +7.73% to 13.93
Quote of the day
“The true investor welcomes volatility. Wild market fluctuations mean that irrationally low prices will periodically be attached to solid businesses.”
- Warren Buffett
3 key principles for long-term investors
Last week, the S&P 500 index closed above 5,000 for the 1st time while also setting a new all-time high – this just ~3 years after it first crossed the 4,000 mark.
While some are understandably nervous any time the market is near record levels, investors also tend to grow more bullish as the momentum continues. Across market cycles, fear often turns to caution, giving way to optimism and eventually irrational exuberance. With the market's rapid climb over the past year, what should investors keep in mind to stay disciplined and focused on their financial plans?
For some investors, it may seem difficult to square this market that only seems to go up despite ongoing financial, economic, and geopolitical uncertainty. The bear markets of 2020 and 2022 even seem like a distant memory now that the Fed is expected to cut rates and inflation has fallen to more manageable levels.
While structuring portfolios to benefit from market gains is important, it's also critical to manage risk. How investors behave when markets are down – even if only for a few days, weeks, or months – is just as important as how they position for when markets are up over the years and decades.
In this context, here are a few key principles to keep in mind.
A smoother ride can help investors stick to their long-term plans
One of the key tenets of behavioral finance is a concept known as "loss aversion," the idea that losses feel worse to investors than gains of a similar magnitude.
A simple example is that finding twenty dollars on the ground will certainly make you happy, but losing a twenty dollar bill will make you substantially more upset. This asymmetry in how we experience gains and losses grows as the amount increases. In the extreme, large portfolio gains may make investors quite happy for a short time but large losses may lead investors to give up on their financial plans altogether.
While most investors would like to generate significant portfolio gains year in and year out, the reality is that markets are inherently volatile, unpredictable, and prone to booms and busts. This is why, from a long-term perspective, it is far more important for investors to build a portfolio and financial plan that they can stick with through good and bad times, rather than a portfolio with the best theoretical returns.
The chart below shows four different asset allocation portfolios and highlights how different their paths have been since the 2008 Global Financial Crisis.
Clearly, an all-stock portfolio would have performed best over the past 15 years. However, there are few investors who can stomach losses on the magnitude of 50% over the course of years. Thus, many other investors would have been better served holding a diversified portfolio instead. Not only would their returns have been quite strong over this period, but they would have been more likely to stick to their financial plan despite the myriad of challenges experienced along the way.
How investors react to bull and bear markets can have long-term consequences
The idea that the timing of positive and negative returns matters is known as "sequence of returns risk."
In a perfect world, whether an investor experiences a bear market or bull market first would not affect the final outcome, as shown in the dotted lines in the chart below.
In reality, however, investors will likely behave differently in bull and bear markets, and they may be withdrawing from their portfolios along the way, creating a drag that is compounded over time.
This is yet another reason investors should be careful of making sharp portfolio adjustments during periods of market volatility and consult with a trusted friends or advisor on portfolio positioning and withdrawals.
Much larger percentage gains are needed to offset losses
The way investment returns are calculated can create a daunting situation for investors. This is because positive and negative compound returns are not symmetric – in general, a larger gain is needed to offset a loss.
For instance, a 10% decline requires an 11.1% gain to recoup those losses. These differences grow with larger percentages, as shown in the chart below. It's easy to see that a 50% decline, which cuts the value of a portfolio in half, would require a 100% increase to return to the original value. The effect of losses on compounded returns is sometimes referred to as a "volatility tax" or "volatility drag."
Thus, in the midst of an inevitable market pullback, it can be easy for investors to become discouraged by the magnitude of the gain needed to return to par. However, history shows that markets do rebound over time, even when the S&P 500 declines nearly 50% as it did in 2008 or 34% as it did in 2020, making up for these losses on their way to new all-time highs.
Of course, the timing of these rebounds is impossible to predict – and as such, it's important to stay invested and not focus on the magnitude of gains and losses.
The bottom line?
While markets have reached new all-time highs, investors should not lose sight of properly managing risk. Diversification allows investors to manage through good times and bad, increasing the probability of success that they will achieve their long-term financial goals.
Source: Clearnomics, CFA Institute
That’s all for today.
Blake
Welcome to The Sandbox Daily, a daily curation of relevant research at the intersection of markets, economics, and lifestyle. We are committed to delivering high-quality and timely content to help investors make sense of capital markets.
Blake Millard is the Director of Investments at Sandbox Financial Partners, a Registered Investment Advisor. All opinions expressed here are solely his opinion and do not express or reflect the opinion of Sandbox Financial Partners. This Substack channel is for informational purposes only and should not be construed as investment advice. The information and opinions provided within should not be taken as specific advice on the merits of any investment decision by the reader. Investors should conduct their own due diligence regarding the prospects of any security discussed herein based on such investors’ own review of publicly available information. Clients of Sandbox Financial Partners may maintain positions in the markets, indexes, corporations, and/or securities discussed within The Sandbox Daily. Any projections, market outlooks, or estimates stated here are forward looking statements and are inherently unreliable; they are based upon certain assumptions and should not be construed to be indicative of the actual events that will occur.