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Equity markets are volatile by nature. To understand why, we must first understand equities. Equities involve an exchange of your cash in return for a stake in a business and hope for a share of future profits by way of direct ownership or a basket of ownership through mutual funds or exchange traded funds. Because nobody can predict the future with perfect accuracy, the pricing and valuations of these stakes can sometimes swing dramatically.
On average, one out of every two calendar years since 1980 has seen a decline of 10% or more (including dividends). Despite this, the S&P 500 has returned positive gains in 82.5% of calendar years for the same period. Long-term returns accompanied by volatility has been a consistent feature of the US stock market.
Every drawdown comes with its own gripping story. Each of the events labelled above were accompanied by headlines that appeared to pose serious issues at the time. There are always reasons to sell, often quite compelling. However, there can often be an economic solution to each of these problems, given enough time.
Because market downturns often come with easily understood narratives of fear and risk, it can be tempting to sell out of equities as markets are sliding and then attempt to buy back in as fears ease. This is extraordinarily difficult in practice. Market bottoms (or lows) often occur when fear narratives are at their peak and they are only identifiable after the fact.
Markets can also be future pricing mechanisms. This means that events expected to happen in the future often become priced in as soon as the information is available. Unless you are able to tell when things will improve before everyone else, it will likely already be priced in.
The cost of missing the initial stages of a rally can be considerable. An investor with $100,000 in the S&P 500 who missed just the best 5 days from 2002 to 2021 would have seen a reduction in their ending value from $616,317 to $389,317. To be clear, that is just 5 days out of a 20-year period. Missing the best 25 days of that 20-year period would knock the ending value down to just $134,392. This may seem surprising but is due to the power of compounding. Missing part of a rally today also results in having less money to compound in the future. When this happens repeatedly, the impact on an investment plan can be catastrophic.
Understanding that markets have produced long-term returns interrupted by bouts of volatility is a key foundation of a good investment plan. We utilize the bucket approach because it prioritizes consistent investment in equities while holding cash and fixed income to finance immediate and medium-term needs. This facilitates a long term approach that historically has yielded the best results.
Personal experience, stock market charts, and history show us that market downturns have always been a consistent feature of investing. They also indicate that those able to hold strong through these periods have been the ones rewarded with the best long-term performance. An investment plan that prioritizes a long-term approach is one of the best tools for achieving financial goals.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request. All investing involves risk including the possible loss of principal.