Staying in the Market

Missing even a few of the best days over an investor’s time horizon will substantially lower the returns. Barring being able to see the future, an investment advisor’s best tools to materially improve an investor’s return are behavioral finance and the power of compound interest. Speaking for all investment advisors, we can’t control the market; speaking broadly again, timing the market is a fool’s errand: the majority of active managers underperform their benchmark. That doesn’t mean an advisor is unable to help you.

Let’s start with highlighting the power of compound interest as one of the tools in the advisor’s toolbox. The example I’m going to use has been passed down for generations, with the first record of this story coming from the year 1256¹:

The Indian King Shirham asks Grand Vizier Sissa ben Dhair what reward he desired for inventing the game of chess.

Sissa responds: “Majesty, I would be happy if you were to give me a grain of wheat to place on the first square of the chessboard, and two grains of wheat to place on the second square, four grains on the third, eight grains of wheat to place on the fourth, and so on for the sixty-four squares.”

“And is that all you wish, Sissa, you fool?” the astonished King asked.

Like the grains of wheat on a chessboard, investment returns compound over time. By no means am I arguing that an investor should expect 100% compound interest for any investment, but even at lower rates of return the figures add up. Consider these historical model portfolios from Vanguard, where they measure the average annual rate of return over 95 years of history. Using the 20% stock, 80% bond portfolio as a conservative example and the 100% stock portfolio as an aggressive example, the average annual returns fall between 7.2% and 10.3%.

At these rates, an investor with $100,000 who relies on compound interest can expect to have between $200,000 and $266,000 after ten years. By the end of the twentieth year, the portfolio will have grown to $400,000 and $710,000 for the conservative and aggressive portfolios, respectively. The true difference between Sissa’s reward and this example is bigger than the numbers – an investor has to be patient for years to receive their reward, and there’s no guarantee of positive returns from a grateful King Shirham. But investors should know this: holding investments for long periods helps improve the odds of higher returns. When advisors encourage investors to stay invested in the market during a sell-off, we’re looking to the power of compound interest and its power over time.

How can an investor develop the resolve to stay invested?

This is where behavioral finance and financial planning come into play. To achieve the long-term investment horizon, an investor needs to first establish and prioritize their goals while charting a safe course through an uncertain future. There are different types of goals, and each investor may rank the same goal differently, but generally financial planners will recommend having sufficient cash or savings to cover your basic living expenses and an emergency fund for contingencies.

Working with your investment advisor & financial planner to better understand your retirement plan’s risk capacity is key to staying in the market. Without an understanding of your goals and priorities, a market correction or sell-off could force an emotional reaction, leading you to sell your liquid assets and miss the power of compound interest. The best financial plans are designed to use all three categories to help build a mental framework to withstand market storms and stay invested.

Markets rarely move in straight lines, and despite historical average annual rates of return over the long run being 6% or more, there are months, quarters, and even years where an investor’s portfolio might show a loss. This is part of investing and is not a reason to quit. During these times I like to refer to this Periodic Table of Investment Returns study from Callan Institute as a reminder that a well-constructed, diversified portfolio will have some winners and losers no matter the market.