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In Volatile Markets, Patience Is Your Friend

Scott's Column

The financial markets have been volatile since the beginning of the year.  After three great years, the stock market has been down significantly in 2022.  Interest rates have risen causing bond prices to fall too.  That’s a double whammy we haven’t seen too often recently.

In the face of this bad news, what, if anything, should you do to adjust your long-term portfolio management strategy?  If you developed a sound strategy in the first place, and built a solid portfolio to implement it, your best bet is to do nothing.

We set out the specifics earlier this month in a webinar and re-emphasized the message later in a detailed written commentary.   But here is the argument in a nutshell.

The Stock Market

There are always grim headlines about turmoil in the financial markets, threats to world peace, or disasters of one kind or another.  Despite the headlines, the stock market rises over time.

Unfortunately, the ride up is not a smooth one.

Since 1980 the S&P 500 index has had positive returns in 32 of the past 42 years.  But in most years, even the positive ones, there have been significant declines at some point.  The average decline is about 14%, which is not too far off the decline we have seen so far in 2022.

As of May 6, 2022, the stock market was down for the year almost 15%.  That doesn’t feel good to anybody.  But looking back over the past 12 months, we are not too far off where we were a year ago.  Not great, but not terrible.  But we are still far ahead of where we were five years ago, even with the recent declines and the Bear market of 2020.

This shows the value of patience in the market.  The stock market’s recent behavior is well within historic expectations.  There is no reason to expect it will depart from historical patterns going forward.  There will be ups and downs, but the market should rise over the long-term.

The Bond Market

Interest rates have been rising.  When interest rates rise, bond prices fall.

The current decline in bond prices is significant.  Since 1976 bond prices have fallen more on only one occasion.  When the bond market reaches historical lows does it make sense to get out of bonds or stay invested and wait for the turnaround?

The historical data shows that rising interest rates and falling bond prices have little predictive value.  That is, the fact that rates are rising, and bond prices are falling in one period tells you next to nothing about how bonds will perform in future time periods.

Bad news today can turn into good news tomorrow.

In fact, this is what we have seen historically when bond prices fall significantly.  When bonds have had their worst 2-year performance, their subsequent 2-year performance has been very good.  If this pattern holds, it would be good news for current bond holders who are patient.

Research also shows that when interest rates rise and bond prices fall, it doesn’t take long for bond investors to benefit from those higher ratesOf course, it depends on the circumstances, but within three or four years bond investors who suffered declines in the value of their bond holdings could actually make more than they would have if rates had stayed the same.

There are two other reasons why it makes sense to continue holding bonds in your portfolio.  The first is capital preservation.  Bonds are much less volatile than stocks.  The second is diversification.  Holding bonds is a very good way to offset the volatility of stocks.

Research shows that during past recessionary periods stocks frequently experienced negative returns during recessionary periods.  Bonds never did.  By combining stocks and bonds in a portfolio you can reduce the number and the magnitude of the negative returns experienced.

Resist the Temptation to Try to Time the Markets

Many people are tempted during difficult times in the markets to cash in their chips and head to the sidelines until things look brighter.  Or they may want to reduce exposure to particular asset classes that aren’t doing well and then jump back in when performance improves.

Market timing doesn’t work.  Despite what your emotions tell you, it is impossible to know ahead of time if you are heading into a bad period and it is impossible to know ahead of time when things have finally turned around.

Research shows that from 2001 through 2020 the “average investor” performed far worse than most asset classes, including stocks and bonds.  This is usually attributed to their efforts to time the market and their tendency to act emotionally when markets are volatile.

You don’t have to predict the future to be a successful investor.  Over that 2001-2020 time period an investor who had simply stayed invested in either a 60 stock/40 bond portfolio or even a 40 stock/60 bond portfolio would have done twice as well as the “average investor.”

Successful investors have patience and discipline.  They learn to sit tight during difficult periods and wait for the better times that always come.