It isn’t discussed much, but when markets take a drop, it sets up a choice for investors with long-term consequences. Investors can stick with their plans, which probably include holding on to stock and maybe even buying more. It can feel like a scary choice if the markets are jumping all over the place. However, the other option is to let emotion rule the day.
Maybe investors don’t have a plan, or they ignore it, and they sell all their stock holdings, convinced it’s better to get out now. After all, it’s much wiser to get what you can out of the markets before it all disappears.
I’ve heard people make both arguments. But when they make the latter one, they skip over something incredibly important: the compounding effect. As a result, the choice to sell all stocks at market lows can create a wealth gap that’s incredibly difficult to close.
One of the best examples has to be Dalbar’s rolling 20-year average return. From 1993-2013, the S&P 500 returned 9.22 percent. Remember that this number accounts for the down years after the tech bubble and the most recent recession. It’s a return almost everyone I know would consider acceptable, and all it required was investing in a S&P 500 fund in 1993 and then doing nothing. But that’s not what the average investor did.
Instead, the average investor jumped in at market highs and cashed out during market lows, which resulted in an average return of 5.02 percent. That’s a gap of 4.20 percent. I know of no investor that would be happy leaving that money on the table. Yet it can happen if we aren’t careful. Just remember the headlines from even a week or two ago. People who previously wondered if we’d ever see volatility again were now worried the market wouldn’t ever settle back down.
It a tough tightrope to walk as an investor, but to give you some context let’s walk through what all too many investors did back in 2007. It wasn’t unusual to hear that people were getting out of stocks and swearing to never buy them again. This decision came with a cost that the Wall Street Journal illustrated perfectly.
“Imagine two well-off households, each with $100,000 in the stock market in 2007. A family that sold in 2009 after losing half its portfolio’s value may now have $50,000 in a savings account. A family that held on would now have about $130,000 in stocks. The inequality has yawned merely because of the investing decisions. In the long run, those savings accounts have a vanishingly small chance of outperforming stocks.”
Besides the fact that we know markets go through cycles, we also know they compound wealth much more efficiently than savings accounts. If you’re lucky, you might find a savings account paying one percent. Compare that to the five-year S&P 500 average of 17.94 percent.
Over those five years, $50,000 in a savings account earning one percent would only be worth $52,551. That same $50,000 invested in an S&P 500 fund would have turned into $114,097. It’s incredibly difficult to recover from that kind of investing misstep, particularly since we understand that $114,097 will continue to compound faster than the $52,551 even if it’s immediately invested into stocks.
So the next time the markets start to dance around and the headlines try to convince you that another Black Friday is around the corner, remember these numbers and the potential cost of ignoring your plan. We’ve worked together to build a plan that takes market movement into account while still helping you get closer to your goals. By letting your plan do its job, you can avoid the classic investor mistake of buying high and selling low. It’s a choice that’s tripped up more than one investor, and it’s one mistake that’s entirely avoidable.