No one could have predicted the rip-roaring returns we have witnessed this year. Especially after a humbling fourth quarter last year when stock markets collapsed by more than 20% from the year’s highs. From the Christmas Eve lows, some markets are up more than 30% and we have witnessed the best start to the year for more than 30 years for the S&P 500. Whenever there is a strong market rally or a sharp downturn in markets, we receive a flurry of questions as market movements evoke emotions, raises questions and cause many people’s trigger happy fingers to start itching. Normally after a strong market rally, there are a few commonly asked questions that are frequently repeated, and the questions reveal the natural biases of investors.
1. How long can it last? When will it end?
Both questions are really about trying to time the market. The first is often asked by people who are not invested in the market and are pained to see it continue to rally (and maybe wish it to stop!). The second could be an instinctive question that arises because you are a contrarian person by nature. It could also be that you are a worrier or a pessimist, focusing on negative outcomes first. Even if you are invested in markets, you are worried that the markets may turn. The bottom line is that these are questions with roots in our instinctive desire to want to time the market.
We want to be able to say we sold at the top and bought at the bottom. We all want to be heroes.
This type of question is one of the most obvious and frequently asked questions during a market rally or even during a downturn. Trying to time the market has been proven to be a futile effort. Just ask those that joined the party late and chased the market into euphoric territories last summer only for it to see a sharp drop or those that sold at the bottom late last year. Trying to time the market is an impossible game. So stop worrying about where the markets are headed and focus on your long term investment plan and stick to it regardless of whether markets are up or down.
2. Why is this going up? Who’s driving this up?
Those that ask this question want to understand what is driving this market. It could be that you are a naturally curious person and want to understand the inner workings of financial markets. Human beings are wired to try and come up with a logic for all that happens around us, especially to explain the past. We often retrofit (also often called backtesting) a framework in which we try to find reasons for the market movements.
Yes it could be valuations were attractive after the market corrected last year, it could be the Fed’s change in policy and subsequent fall in rates supporting the outlook, it could be that corporate earnings so far this quarter and also the economic growth has surprised on the upside, it could be hopes of the US-China trade wars ending.
Trying to understand the cause of financial market movements is an admirable effort but finding good reasons for why the market is up may sit well with our internal rationalizing but it is a poor predictor of future returns. In fact, thinking that we know what caused the market moves in the past often results in overconfidence in our ability to predict the market in the future.
This constant desire to act is the beast inside us that we must all tame.
History may rhyme but it never repeats itself in the same manner, especially when it comes to financial markets. The market is a collective decision-making process resulting in constant price discovery, with all known public information being priced into the market at any given point in time. It is a voting machine in the short term and a weighing machine over the long term. No one can consistently expect to have a better understanding or an information advantage that will sustain an investment advantage. That is why investing broadly and consistently in markets is the right way to go over the long run.
3. Should we chase or buy more? Should we sell and take profit?
These questions reveal the natural bias of the person asking the question. The former is biased towards greed. The tendency for the person is to lean toward a momentum style of investing and prone to chasing euphoria. The latter is biased towards fear. Hallmarks could include scepticism and a contrarian streak.
Especially when markets rally, the crowd divides into largely these two main camps. Those driven by greed and fear. These are primitive and natural desires that drive the impulse to chase market rallies or to lock-in the profits and flee. But history teaches us that price movement should not be the basis of an investment strategy. A solid empirical and evidence-based investment strategy is the only one that works over the long term. Anything else that may seem like it works over the short term can be attributed to just plain dumb luck.
4. Why didn’t I invest more?
This is a question we hear a lot but obviously it is a rhetorical question. When it is asked, it is often accompanied by another statement such as “you should have told me to buy more or invest more.” Placing blame on others including your advisors for these decisions is akin to placing blame on your child for not being a world-class soccer player. There is a role to be played by the parent in guidance but a lot of it is just DNA. It is also called hindsight investing. In hindsight, we should have invested more. It normally implies also that you were too risk-averse to put all your cash to work in the markets. This concept of risk appetite is important as when markets are good, we may kick ourselves for not investing more, but when markets are falling, we may also be the first to head to the exit. Thus gauging the correct level of risk that is appropriate for you and sticking to it is an important first step in financial planning and it will help improve the chances of your investment success.
5. Should we wait for a correction to add to the position?
This is a more realistic or pragmatic action question. While it may sound like a great question - it is a passive-aggressive question. We are regretting that we didn’t invest more or didn’t invest all of our money or enough of our money. We want to put it to work but don’t want to chase the market. So we are hoping for a correction to add to the position. In a sense, we are again trying to time the market.
What we should be doing is utilizing a dollar cost averaging strategy to regularly save and invest. If we had done that then we would not be worried about a correction or that we are missing out. We do not know whether the market will continue to rally from here or correct meaningfully. We should be willing and pragmatic to accept that either outcome is possible and we will continue to act out our investment plan regardless of where markets are.
Endowus is about advancing the human experience of money.
The behavioural aspect of managing money is an important part of what we want to improve in our experience of investing. What we should control is not the timing of our investments but our own emotions, and the behavioural mistakes we are prone to make driven by these emotions.
Studying the past is how we learned many of the truths of financial markets that are embedded in our Endowus investment philosophy. These truths have been proven across markets and through cycles, such as the benefits of asset allocation and diversification, the significant negative impact of high costs to returns, and the enduring power of markets to reward the long-term investor. We have also learned the futility of market timing, the weak and inconsistent outcome of active management, and the need to tame our emotional behaviours. Let us learn from the past and improve our chances of a better outcome in the future.