There was a very interesting article this week regarding diversification against long-term investment. The idea was simple; does it make more sense to invest in the stock market on a long-term basis than trying to trade through the ups and downs?
Protection from stock market crashes
At some point you will hear all investors discuss stock-market crashes, often trying to predict when markets will peak and investors will bail out. The truth is that history shows stock-market crashes are not predictable and it can be one of a number of reasons which could prompt investors to flee. Over the last 50 years there have been three (arguably four) major stock-market crashes in the US. We saw markets suffer in 2007/8, the turn-of-the-century and in the early 70s (although some will point to the 1987 crash as well). So, if you are diversifying your portfolio to protect yourself against a stock market crash then three in 50 years is fairly rare?
As a consequence, those looking to diversify their portfolios into for example government bonds as a hedge against a stock-market crash will miss out on significant long term stock-market performance. True, they may well protect themselves from a crash tomorrow but now let us take a look at the longer term picture.
Peaks and troughs
Those who actively manage their investments will likely try to sell out before a stock-market crash “gets too bad” and then by back in when things start to recover. It is not inconceivable that you could see a 40%/50% swing between the top of the market and the bottom. So, if you weren’t selling at the top and you weren’t buying at the bottom then over time you could be losing out on significant performance. The fact that historically markets tend to bounce back to higher levels in the longer term suggests that maybe long-term investment is the way forward?
The example published this week saw an investor “plunge their life savings” into an S&P 500 proxy fund on 31 December 1998. Some 20 years later the hypothetical portfolio had increased by 292% with dividends reinvested. The swings in the index were huge, 50% in the 2000/01 crash and 53% in the 2008/9 crash. This example shows that you need to have a spread of investments across an index such as the S&P 500 as opposed to picking individual stocks yourself. However, there are is an array of collective investment vehicles available which allow you to replicate this type of strategy.
Living through the pain
Many investors look longer term for their retirement and to see the value of their portfolio plunge by 50% on two separate occasions over the last 20 years would have been mentally challenging to say the least. However, the long-term result shows that sticking with stock markets can be extremely beneficial. Let’s not forget, stock markets are not only a platform on which you can trade shares but companies, and indeed governments, can also raise equity to expand and finance different events.
The world is littered with individuals who have made serious amounts of money by “gambling the house” on one or a very small number of stocks. If they do well the returns can be monumental but if they do badly, they could be wiped out. So, take a long hard look at your investment strategy, plan ahead for the future and if you are not overly keen on being an active investor, invest into an index proxy fund. Then you can sit back and enjoy the ride, if enjoy is the right word!