The science behind keeping investments in lockdown
By Collin Nefdt
RANDS & SENSE:
The speed of the market crash and the subsequent bounce-back reveal once again that the real danger to long-term investment returns is not market volatility but investor behaviour.
We all know the markets swing between highs and lows. When the dip is as dramatic as in the Covid-19-induced market sell-off, it’s not always as easy to keep faith. However, when long-term investors don’t hold their nerve and opt to switch to lower-risk assets during a crisis, they lose out in the long run.
Many investors have been surprised at the sharp stock market recovery. Granted, the Covid-19 pandemic is a unique event; but we need to remember that investor behaviour is not. Extreme market volatility occurs when the embedded emotions of fear and greed are amplified – heightened fear is virtually universal in how we react to a crisis.
Recovery is, therefore, in the nature of the markets, and perhaps the best way to see this is to reflect on the long-term trends of an actual fund. The track record of the first equity mutual fund in the US, launched in 1924, and that of the first balanced fund, launched five years later, illustrate the point. These are the Massachusetts Investors Trust (MIT) and the Vanguard Wellington Fund, respectively.
Plotting their growth since 1930, which included the effects of the Great Depression and every other major market event since, we found that the MIT has delivered a real (after-inflation) compound annual growth rate (CAGR) of 6.1% compared with the balanced fund’s real CAGR of 5.2%.
This long-term perspective is important, as it demonstrates that the funds have stood the test of time and shows that long-term investment programmes do not have to be derailed by a single market event.
This overwhelming evidence of the resilience of markets to produce positive returns over the long term is a powerful tool for investors.
The pandemic has provided three key lessons to reinforce the importance of trusting the markets:
1. Follow the science. The near 100-year track record of the two pioneer funds is the strongest evidence that long-term wealth creation is not a continual, straight, upward-sloping line. A buy-and-hold investor of the actively managed MIT fund, for instance, would have experienced three prolonged periods of little or no real growth. In between such phases, however, there were periods of rapid appreciation.
2. Flatten the (risk) curve. Investors in balanced funds can take comfort from the smoother return pattern over the long term. This shows that the diversified nature of the fund does as advertised by spreading exposure across different asset classes.
The diversification embedded in balanced funds can smooth the long-term investment journey, but naturally, this will come at a return discount. If we overlay the annual returns of the diversified Vanguard Wellington Fund over the equity-based MIT fund, we see that the incidence and degree of negative returns are lower.
The argument is that the balanced fund return pattern, with its ability to dampen losses, can help to keep investors invested when times are tough.
3. Keep your investments in lockdown. The final lesson is an age-old one: stay the course. The two funds clearly demonstrate this in their respective long-term returns. The higher return from the MIT fund is not surprising, as equity funds should outperform a balanced offering over time. This differential will be “banked” only if you have stayed the course and not withdrawn from the market.
This is an important lesson for retirement fund members, who will have experienced a sharp decline in their retirement account values over the past few months.
The real-world results from these two funds help to drive home the message that single market events are unable to prevent investment markets’ steady, inevitable rise.
Collin Nefdt is an investment specialist at Old Mutual Corporate Consultants.