When markets keep rising, we can forget why a long-term mindset is valuable. In a nutshell, investing over the long term is one of the best ways to minimize short-term equity risk exposures. Market cycles do exist, can be long, and are unpredictable, and if you’re not managing for them, they can have a significant impact — both good and bad — on your portfolio.
I personally define “short term” as meaning one to upwards of 10 years, although most investors define it as one to five years. There’s no wrong answer. I think it comes down to expectations of what could happen within your definition of “short term” and whether you’re comfortable with those risks.
Equities and stocks are not only incredibly volatile in the short term, they can also experience negative returns for long periods of time. The concept of “stocks for the long term” assumes that investors can be highly confident that equities will outperform in the future because they have in the past.
I’m not so sure. Investors never know with a high degree of certainty what the future holds for stocks, nor can they be very certain what future volatility will be. This uncertainty is at the core of why stocks can or should offer investors higher rates of return: Because you don’t know! If the risk doesn’t happen, you get the return; but, if the risk does happen, you don’t get that return (and, in fact, you could lose money).
So, yes, stocks have historically outperformed bonds over very long periods of time, and yes, because of the higher uncertainty stocks carry, they should offer investors a higher return. But stocks can and have lost significant value in short to intermediate periods of time, and since that can happen during a time when you may need the money, the long term needs to be clearly embedded in your mind.
For example:
- Bear markets and recessions have occurred in most developed nations about three times every 10 years.
- U.S. stocks have gone more than a decade with performance less than or equal to that of bonds.
- Furthermore, over the past 200 years, U.S. stocks have declined as much as 90% in a single holding period. In 2008-09, many global stock indexes lost more than half of their value.
- It’s possible for entire countries or indexes never to recover their losses in one’s investment lifetime. Just look at Japan in 1989, or the 2000 Nasdaq tech bubble.
(Continued)
Just as it is important to realize that stocks can be risky, especially in the short term, bonds and cash can also be risky, especially in the long term. Inflation tends to eat up a lot of the return bonds and cash provide. Furthermore, taxes can take a piece of your interest income every year, so the after-tax, after-inflation-adjusted return in a bond portfolio can be poor over long periods of time. Bonds primarily benefit one’s portfolio through volatility control and current income yield. Because of the unpredictability of market cycles, it seems prudent to own both.
Few investors have the patience to see a portfolio of stocks do nothing for decades, but they often don’t notice how a portfolio of bonds could lose dramatic purchasing power until it’s too late. Unfortunately, if you’re an investor, you really need to be prepared for very long-term holding periods and be ready for adjustments to deal with cycles.
It seems, then, that you should mentally prepare yourself by understanding that cycles happen and your biggest investment advantage is to have a long-term mindset. You should also understand what risk you’re comfortable taking and realize that risk can mean loss as much as it can mean opportunity. You should probably prepare yourself financially by setting aside funds for an emergency and always have short-term needs set aside in cash equivalents or investment grade short-term bonds outside of your long-term portfolio. Don’t “invest” for short periods of time, but rather “save.” Keep the concepts separate in your mind.
Training your investing mind and keeping your behavior in check could be your best use of time as an investor. Or you simply don’t “invest” at all if you can’t or don’t want to exercise a long-term mindset. You then have to choose to save a lot more and spend a lot less and hopefully avoid any impacts of inflation over time.
Michael Dubis is a fee-only certified financial planner and president of Michael A. Dubis Financial Planning, LLC. He is also an adjunct lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at financialperspectives@gmail.com.â¨â¨ This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described in this website or that of the author’s. Mike Dubis does not guarantee the relevancy, appropriateness, or accuracy of any outside information or links. Mike Dubis does not render or offer to render personalized investment advice or financial planning advice through this medium. All references that might be made to an investment or portfolio’s performance are based on historical data and one should not assume that this performance will continue in the future.â¨THIS COMMUNICIATION MAY NOT BE USED BY YOU AS A RELIANCE OPINION WITH RESPECT TO ANY FEDERAL TAX ISSUE DISCUSSED HEREIN AND IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY YOU FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU BY THE INTERNAL REVENUE SERVICE.
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