Financial markets have had a rocky start to the year. Major stock market indices have fallen a few percentage points as investors adjust to sharply higher interest rates, rising inflation, and faster Fed tightening. While this has been a shock to markets, long-term investors have seen episodes like this many times over the past decade. Rather than focusing on short-term market news, it's more important than ever for investors to hold onto well-constructed portfolios to start the year off right.
History shows that staying invested with an appropriate portfolio and financial plan has been the key to long-term success. Doing so helps investors to capture the upside as markets rise over long periods while protecting from downside when they inevitably decline over shorter ones. In doing so, investors can better fight the temptation to jump in and out of markets when daily or weekly swings occur.
Just as a sensible sedan, SUV or minivan may not be able to keep up with a race car on an open highway, they will handle the inevitable potholes and traffic jams much better. And, in the end, they will reach their destinations in a safer and more comfortable manner. Today, there are three key reminders for investors during this period of uncertainty.
First, short-term stock market pullbacks are not only normal but can happen at any time. They are not a cause for panic but can serve as a reminder of why we build portfolios and seek financial guidance in the first place. There are typically four or five market pullbacks of 5% or larger each year that tend to fully recover within weeks or months. Thus, the fact that the S&P 500 is down over 3% and the NASDAQ over 6% year-to-date (as of this writing) may seem significant at first, but this is par for the course.
The challenge for investors is squaring the news that the market is down with the fact that markets tend to rise over longer timeframes. The key is that risk and reward go hand-in-hand. The ability and fortitude to take intelligent and well-considered risks is exactly why investors are rewarded in the long run.
Second, rising interest rates and Fed tightening are natural and expected at this stage in the business cycle. However, they often require a period of adjustment which the market is undergoing right now. This was true in 2013 during the Fed taper tantrum, in 2015 when the Fed announced its first rate hike that cycle, last year when the Fed was expected to taper again, and so on.
The Fed's job is not to keep rates low or to stimulate the economy indefinitely. Instead, the Fed's goal is to maintain full employment and stable prices. Even if inflation were not at multi-decade highs, the strength of the economy would justify raising rates at this point in the economic expansion. History shows that once markets and businesses adjust, interest rates tend to rise alongside the economy.
Additionally, the topic of the Fed can be controversial among investors. However, many have been calling on the Fed to normalize its excessively large balance sheet and too-low interest rates for over a decade. The fact that inflation is higher-than-expected has pushed to Fed to do exactly this.
Third, while many factors have pushed markets to ever-higher levels over the past couple of years, investors should have realistic expectations for the economy and markets. Although once-in-a-lifetime levels of GDP growth and job gains kicked off the economic recovery, the next few years could experience steadier, more traditional levels of growth. Broad market valuations remain close to dot-com era highs but can improve over time as earnings grow.
This is important because it may be tempting to try to eke out gains by trading in and out of markets. But once again, history shows that it is often better to simply stay put. Over the past 25 years, the hypothetical average investor that held onto their stock allocation gained at least twice as much as an investor that tried to exit and re-enter markets at a later date. In fact, because markets tend to recover unexpectedly and rise over time, the longer an investor stays out of the market, the more they potentially miss. Of course, there may be fully justifiable reasons to tilt a portfolio based on sectors/styles/geographies or to re-allocate if financial goals or personal situations change.
Thus, investors ought to stay focused in the weeks and months to come. The timing of market swings is impossible to predict but the fact that they occur is a certainty. The goal of long-term investors is not to swerve in and out of markets based on past returns, but to stay invested in an appropriate portfolio through both good times and bad. Below are three charts that highlight the challenges investors face as markets adjust.
1. There are several market pullbacks each year
The average year experiences several stock market pullbacks and there's nothing special about the fact that this is occurring at the start of the year. Thus, while the current pullback seems alarming and involves big issues such as inflation and the Fed, long-term investors know this is typical for markets.
2. Investors are rewarded for long-term thinking
There have been very few periods when the market has been down over long timeframes. While average returns can vary significantly based on market cycles, those investors who can focus on years and decades will likely increase their odds of success.
3. Staying invested is better than trying to time the market
While trading in and out of markets may be tempting, history shows that it's usually better to stay put. In fact, it's not even close. The chart above shows the benefit of staying fully invested instead of being out of the market for one week or one year after market pullbacks.
The bottom line? Short-term market pullbacks are normal and inevitable. Investors ought to focus on their financial goals over years and decades rather than market swings over the course of days and weeks.