The Risk of Reacting

By C.J. Baxter

Many investors are feeling a little jittery these days, and rightfully so. We have had to deal with fears of Ebola, constant tension in the Middle East and a sluggish overseas economy. And that short list fails to mention we recently went through one of the biggest market pullbacks since The Great Depression. With the events of the 2008 crash so close in the rear-view mirror, many investors think the latest market volatility means that we are now doomed to repeat that down cycle (we call this a “recency” bias).

However, when things get a little unnerving, don’t conclude that it’s best to just sit on the sidelines for a while and then get back into the market when it’s “safe.” It never really is. Instead, consider the graph below.

It illustrates how missing out on just a few days or weeks can hurt your performance. The graph presents the annualized compound return and growth of $1,000 dollars invested in the S&P 500 Index from 1970-2013.

riskofreacting

The first bar shows us that staying invested throughout this period would have produced an annualized return of 10.40 percent. Now look at the third bar, and you will see that missing out on the five best single days during this period could have reduced your performance to 9.33 percent. Now let’s look at the fifth bar. As you can see, this bar demonstrates that missing the 25 best single days in that period would have reduced your return to 6.86 percent. That’s a difference of 3.54 percentage points. And it’s from leaving the market for only 25 days (less than a month) over a 33-year period.

Now, to really drive the point home, let’s frame this scenario with a larger dollar value. If you invested $100,000 in 1970 and applied the index’s performance of 10.40 percent compounded annually over the same period, you would end up with $7,780,400. That’s what you would earn from staying invested the entire time. If you use the same scenario, but plug in the 6.86 percent return, compounded annually, that an investor would earn from of missing the 25 best days, you end up with $1,853,300. The difference is more than $5.9 million. What would you do with that additional money?

This is why it’s so important to have a solid investment plan in place. If your plan is built to suit your goals and risk tolerance, hopefully you won’t feel the need to jump in and out of the market. Another crucial aspect of such a plan is to engage a fiduciary advisor, who will make sure that you stick with it.

Recently, I reached out to reassure a client about the market’s volatility. He simply responded back, “That’s what seatbelts are for!” Not only did I get a good chuckle, but I realized that it made a great metaphor for the role of an advisor. When the road gets rough and bumpy, advisors are there to make sure you don’t go flying off course, keeping you buckled down and disciplined so you can reach your financial destination in the most prudent way possible.

Disclosure: Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. In U.S. dollars. Performance data for January 1970-August 2008 provided by CRSP; performance data for September 2008-December 2013 provided by Bloomberg. The S&P data are provided by Standard & Poor’s Index Services Group. U.S. bonds and bills data © Stocks, Bonds, Bills and Inflation YearbookTM, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).


Copyright © 2014, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

Privacy Policy | Legal Notices | Sitemap