After a relatively flat year, 2016 has kicked off to a less-than-enthusiastic start. As with any coverage of the stock market, you will have those that proclaim the great rise of stocks ahead, and others that spout doom and gloom and warn of the next inevitable crash (and usually at the same time). The past few days have been no different. The recent increased volatility has put investors on edge, tempting some to consider reducing their exposure to stocks and others to contemplate selling out of the stock market altogether. It is difficult for investors to watch the market go down, and it is during these times when investors are especially vulnerable to being affected by the ‘herd mentality,’ causing many investors to run for the exit at any sign of bad news. Unfortunately, it is these emotional reactions that cause investors to make irrational decisions that adversely affect their performance.
Even when the market is down, investors don’t truly lose unless they sell. When investors panic and sell their stock when the market drops, they lock in that loss and position themselves to miss out on the inevitable turnaround and on crucial compounding. Unfortunately, by the time investors get back in on positive news it’s usually too late, and they have missed out on part of the upswing. Some of the biggest market gains occur during these very short periods. If investors miss just a few days of those gains, they will substantially under-perform those that stayed invested long-term.
Morningstar conducted a study based on a portfolio of individual stocks in two different scenarios. A diversified portfolio of $10,000 invested over the last 30 years ending February 2013 earned 10.7 percent and grew to $476,000. If the investor missed only the best 10 trading days of those 30 years, the portfolio earned only 7.5 percent and grew to $156,000. That is 67 percent less than if the portfolio stayed fully invested through the up-and-down markets. Market timing doesn’t work – successful investors hold for the long-term.
Compounding is a crucial and often overlooked component as to why staying invested is so important during a down market. While some investors usually bemoan the idea of a temporary down market, long-term investors get excited because it gives them an opportunity to deploy cash into fundamentally solid companies that become undervalued, or “on sale.” This does not only apply to new money added to an account, but also to dividends received on current shares.
When an investor receives a dividend, a down market allows the investor to purchase more shares than they would be able to when the market is up, which in turn means more dividends and more shares in the future. This compounding can increase an investor’s return substantially over time.
No one can predict where the market will be in one week or in 10 years. Watching your account minute-by-minute and making changes based on what you see, hear, or read will cause nothing but stress, potential loss, and lots of trading costs. While it is difficult to watch the stock market go down at any time, historical and academic data prove time and again that staying fully invested pays off.