The uncommon average

The uncommon average

Photo by Mike Cohen on visualhunt

When investing, it is important to decide on what you believe and are happy to implement.  As David Booth the founder of Dimensional Fund Advisers said, “I have found that the importance of having an investment philosophy, one that is robust and that you can stick with, cannot be overstated.”  Basically, find an investment plan and process you are happy with and stick to it.  Wise words. 

One of the most important rules when embarking on a long term investment portfolio that includes assets with values that fluctuate due to market pricing is to stay the course. 

At Bloomsbury we help all our clients, whether we are managing some or all of their long term investments, to evaluate their risk profile and in particular their tolerance to investment risk.  We do this to agree what level of exposure to growth assets (equities and global property) our clients are comfortable with, so that when the inevitable market falls occur they are happy to stay the course. 

Another way of describing this approach is to buy, hold and rebalance (maintaining the asset allocation you are comfortable with).  Evidence suggests that it is not possible to influence market returns, and consistently beating the market is very difficult, so why bother when a market return is usually enough for most people.

If we look at global equity markets, they have delivered an average annual return of around 10% since 1970[i].  However, the short-term returns may vary, and in any given period equity returns can be positive, negative, or level.  In order to hold your nerve and stay the course it is important to set reasonable expectations of returns.  You can do this by looking at a range of outcomes experienced by investors historically.  For example, how often have the stock market’s annual returns actually been aligned with its long-term average?

If we look at the calendar year returns for the S&P 500 Index since 1926 we can see that over this period, the average annual return has been 10%. However, the S&P 500 Index had a return that was plus or minus 2 percentage points of its average (8% to 12%) in only six of the past 93 calendar years[ii].  In most years, the return was outside of 8% to 12%, often considerably above or below by a wide margin.  There is also no obvious pattern so trying to predict future returns of this index (and probably any other) by looking at historic data is a ‘fool’s errand’ but we knew this already.

The data highlights the need to look beyond average returns and being aware of the range of potential outcomes given the allocation of your long term investments to equities.  If you can ignore short term fluctuations (accepting that these will occur and may be uncomfortable) whilst staying the course and sticking to your plan, then the longer you can stay invested the better your outcome is likely to be.  The S&P 500 index for example has provided a positive return in c.94% of 10 year periods from 1926 to 2018[iii].

While you may find it easy to do this in years with average returns, periods of lower or negative growth may test your nerve and faith in equity markets being able to provide the return you need to meet your goals. Understanding that a range of potential outcomes are highly likely year to year can help you remain disciplined, which in the long term should increase your odds of a successful investment experience.

So, what can you do to endure the ups and downs that are going to happen?  The first thing is to have an understanding of how markets work.  This and trusting market prices are both good starting points.  You then need to align your investment asset allocation with your personal tolerance of investment risk and your financial goals.  You will then be better prepared to stay focused on your long term goals during all market conditions. 

Cheers

Charles

[i] As measured by the MSCI World Index (gross dividends) in US dollars from January 1970–April 2019. MSCI data © MSCI 2019.

[ii] Source: Dimensional Fund Advisors Ltd.

[iii] Source: Dimensional Fund Advisors Ltd.