October has been a tough month for stocks, with many indices down almost 10% in the past month and some of the high-flying tech stocks down 20%. With the recent activity in the stock market, it seems a prudent time to review some evidence-based tenets of wise investing.
- Make Volatility Your Friend. Market corrections of 10% or so are normal and have historically happened about once a year. Stocks are a risky asset class, which is why investors demand higher returns to invest in them. In order to earn their higher long-term returns, one needs to accept the short-term volatility that comes with them. The wise investor resists the temptation to dump stocks and sit on the sidelines until calmer seas arrive and instead looks for opportunities to invest spare cash in things that have gone down the most.
- Diversification Helps. Asset classes go through cycles of leading and lagging each other and it’s impossible to know in advance which ones will do best in the coming year or so. By owning a globally diversified portfolio of stocks and bonds, investors reduce the risk of being in the wrong place at the wrong time. While the 2000s were a “Lost Decade” for large US stocks (as measured by the S&P 500 index), non-US stocks did well over that time frame, as shown in the chart below.
- It’s Best to Stay Invested. Research shows you can’t time or beat the market, so instead of trying to do so, it’s best to stay invested even when things get scary. One long-running study (by DALBAR) shows the average stock investor earned 5.3%/year over a 20-year period when the S&P 500 earned 7.2%/year, reflecting the fact that individual investors tend to trade too frequently and at the wrong times. If you feel the need to do something, then rebalance back to your long-term asset class targets as this causes you to buy what has gone down and sell what has gone up. Or talk to your tax professional or financial planner about tax-loss harvesting investments in taxable accounts that might be at a loss.
In summary, it is human nature to want to flee from danger, our rational self knows that wise investors stay focused on their long-term plans and use volatility to their advantage.