Embracing the long game in turbulent markets

Source: Bloomberg, Peters Financials

In times of market volatility, where fluctuating interest rates, economic instability, and geopolitical conflicts stir the pot, it's understandable for investors to experience feelings of uncertainty, doubt, and despondency. It's in these moments that the advantages of long-term investment strategies come into sharper focus, highlighting the risks associated with placing too much emphasis on short-term news and events. A shift in perspective to appreciate the long view can help mitigate the knee-jerk reactions to the often transient and sensational headlines that dominate the financial news cycle.

In the world of finance, few topics are as universally accepted and praised as the benefits of long-term investing. This strategy involves the buying and holding of stocks for extended periods, often years or even decades. Since the end of the World War II, the S&P 500 increased more than 100-fold. In the last decade, the annualized return for the S&P 500 stands at 12,39%. Meanwhile, the MSCI World Index reports a slightly lesser yet impressive annualized return of 10.5% over the same period. Easy, right? Unfortunately, neither private nor professional investors, on average, came even close matching that track record. What looks easy in theory is, in fact, extremely challenging in the real world. As it turns out, it’s not just about charts and numbers, it’s also a test of psychological fortitude.

The illusion of market timing versus the rewards of time in the market

The most important feature of the long-term equity returns mentioned above is that they are not linear or evenly distributed. The shorter his time horizon, the more an investor is merely observing the variability of the portfolio, or as Nassim Taleb would put it, being “fooled by randomness”. To illustrate this with data, the historical likelihood of making money in the US stock market stands at 50% over one-day periods, improves to 68% for one-year periods, increases to 88% in 10-year periods, and, to date, reaches a certainty of 100% across 20-year periods. Yet, paradoxically, these short-term fluctuations are crucial in shaping overall portfolio returns. For instance, during the decade from 1994 to 2004, missing just the top ten trading days would have halved your investment return compared to the S&P 500, dropping it from 12.07% to 6.89%. If you missed the best 30 days, your return would be negative. Against this backdrop, "market-timing" — the strategy of attempting to outperform average returns by simplistically buying low and selling high — often backfires. As the investor Terry Smith has pointed out: “Such approaches to investment are almost all futile. Markets are second order systems. What this means is that in order to successfully implement such market timing strategies you not only have to be able to predict events — interest rate rises, wars, oil price shocks, the impact of the coronavirus, the outcome of elections and referendums — you also need to know what the market was expecting, how it will react and get your timing right. Tricky”. In fact, as studies have shown, over a long-term period, only a single digit percentage of the most extreme market-timers, the so-called “day traders”, have made any money at all. It is as if they all went to Las Vegas, without the fun and free drinks.

Leverage, impatience, and inactivity: navigating the pitfalls of investment psychology

In “The Psychology of Money”, Morgan Housel recounts how in the early years of Berkshire Hathaway, Warren Buffett and Charlie Munger were accompanied by a third partner, Rick Guerin.  Unlike his colleagues, Guerin wanted to get rich quickly by using leverage. However, during the market crash of the 1970s, he faced a margin call that necessitated the sale of his stake to Buffett at $40—a figure close to the all-time low.  The lesson here is that, even if you are holding a large position in what is arguably the most successful investment company in history, leverage can force you into making catastrophic decisions. Worse, as most investors at one point or other make mistakes, those mistakes get exacerbated by debt. Rather than allowing investors the chance to recover and learn from their missteps, they may find themselves completely financially devastated.

Next to debt, investors’ tendency to pursue the highest short-term returns is another catalyst for bad performance, albeit mostly a less lethal one. At any point in time, even during bear markets, certain market segments and sub-sectors will perform well. Seduced by rapid gains, investors often rush into these currently thriving areas at inopportune valuations, only to see short-term gains evaporate and turn into losses when market favor shifts to a different set of stocks. In some instances, such as when individuals flock to the more esoteric segments of financial markets—like unprofitable early-stage technology companies, cryptocurrency ventures, renewable energy stocks, or small-cap miners—the consequences can be dire.

Finally, while excessive trading seldom yields positive outcomes, inactivity is equally disadvantageous. A steadfast commitment to a single industry or trend usually results in underwhelming long-term returns, given that the global landscape is in constant flux, with industries and companies rising and falling. Investors who, reflecting on the devastation of the dot-com crash in 2000, chose to avoid investing in technology, would have forfeited substantial gains. Likewise, those who, fixated solely on GDP growth, obstinately maintained a majority of their investments in emerging markets have reaped minimal rewards over the past decade.

Investment trends are transient, and no single investment strategy is perpetually effective. However, the essence of successful investing is endurance. It is only by persevering through market fluctuations that one can harness the long-term investment returns previously discussed. In pursuit of this objective, simplicity often trumps complexity. Instead of striving to mimic the strategies of the most celebrated investors, it is beneficial to remember Napoleon’s adage: “A genius is a man who can do the average thing when all around him are going crazy”.

How outliers shape investment success

A 2014 study JP Morgan Asset Management tracking all stocks in the Russel 3000 Index since 1980 showed that 40% of them lost at least 70% of their value and never recovered, and that effectively all of the index’s overall returns came from seven stocks. Warren Buffett owned 400 to 500 stocks over his lifetime. Yet, the majority of his wealth accumulation can be attributed to his investments in merely 10 of those stocks, which have consistently yielded returns exceeding 20% annually.

Market analysts frequently perceive the aforementioned phenomenon as a drawback, as illustrated by the puzzled reactions to the "magnificent seven" stocks that propelled the entirety of the stock market's performance in 2023. Yet, for the long-term investor, there's an optimistic aspect to consider: It's possible to make numerous incorrect decisions and still emerge successful. To use a basketball analogy, Michael Jordan once said: “I've missed more than 9000 shots in my career. I've lost almost 300 games. 26 times, I've been trusted to take the game winning shot and missed. I've failed over and over and over again in my life. And that is why I succeed.”

Meanwhile, returning to the point raised above, the same pattern plays out when looking at the role of time in an investment portfolio. Comparable to the impact of select stocks, a handful of days or weeks can be pivotal for long-term financial outcomes. How you behaved in the maelstrom of the financial crisis of 2008-09, or during the first COVID-19 lockdown in 2020, may define your investment returns over your lifetime. Tails drive everything.

It's noteworthy to mention that the very notion of maintaining an investment portfolio is, in itself, a rare occurrence. Although money has been a medium of exchange for thousands of years, the concept of managing an investment or retirement account is a modern development. Even in today's age of abundant investment options, including mutual funds, index trackers, and a myriad of financial instruments, the possession and management of a substantial investment portfolio often result from an event with slim chances of occurrence, such as exceptional professional achievement, the successful sale of a business, or the fortuitous circumstances of one’s birth.

No Free Lunch

To rational, patient, long-term investors, equities offer great long-term returns. However, they are not easily attained. In the past 170 or so years, stock markets have fallen by more than 10% over 100 times. They fell by more than 30% more than 10 time. Just in the past 25 years, we have seen a dot-com bubble followed by a crash, 9/11, the demise of Lehman Brothers and the Great Financial Crisis, the Eurozone crisis, Covid-19, the lowest interest rates ever followed by the steepest interest rate increases in history, the invasion of Ukraine, and rolling crises in the Middle East. Stoicism in the face of such turmoil is difficult. Alas, short-term pain and volatility are the price to pay for long-term returns in the low double-digits. Moreover, those who claim they can offer similar returns “risk-free” are usually misleading. Often, they are understating the risk, and skimming part of the upside (through fees, or expensive derivative strategies). In some cases, such as Bernie Madoff’s linear 1% per month returns, they are outright criminals. Nothing in life is free. For 90% of the time, stocks are at least 5% off their highs. That uncomfortable feeling, wondering if you should have sold, is the price to pay.

Emotional resilience in investing: beyond numbers and theories

While the discussion above advocates for stoicism, risk-management, and taking a long-term time horizon as important principles driving positive investment-returns, how an individual investor implements these can vary. Ahead of his fight with Evander Holyfield, the boxer Mike Tyson famously quipped that “Everyone has a plan until they get punched in the mouth.” In financial markets, no one knows how they will react to a 20-30% drawdown in their portfolio until they actually experience it. Behind the numbers, investors are human, each with different unique personal circumstances, experiences, and genetic make-up. Someone who lived through the Great Depression will likely behave differently than someone who grew up in Silicon Valley during the 1990s.

It is, thus, impractical to establish universal investment guidelines beyond the foundational principles of stoicism, risk management, and maintaining a long-term perspective. For some, opting not to be "fully invested" might be strategic if it helps them endure market downturns more comfortably. Although frequent trading typically fails to yield positive results, allocating a minor segment of one's portfolio for active trading could be beneficial for certain individuals, provided it satisfies an underlying need and allows them to manage the majority of their investments with minimal interference. Likewise, selecting stocks from companies whose products they admire or which operate within close geographic proximity may not be the most logical strategy, but it can provide the emotional resilience needed to remain invested during challenging times.

As NYU Stern Professor Scott Galloway once said, “Nothing is ever as good or as bad as it seems”. While in financial markets a “goldilocks” scenario rarely lasts long, so do protracted downturns. It is therefore imperative to be “in it to win it”, and to learn along the way.