The past several weeks have seen some volatility return, with global stocks falling -3.9% from 6 September to 4 October’s low, then rebounding almost to breakeven by last Friday’s close.[i] Still, some financial commentators we follow have suggested now is the time to reduce equity exposure and raise cash, arguing the likelihood of more negativity is high. Holding more cash in anticipation of rocky market stretches may sound sensible, but we think doing so could cost you dearly if you need long-term growth to reach your investment goals. Let us review.
There are myriad reasons for holding cash, though some are more beneficial than others, in our view. For example, cash is a near-necessity in an emergency fund (savings earmarked for unexpected expenses) or for a known or planned expenditure—two scenarios where subjecting capital to any volatility, which may lead to short-term losses, can pose a huge problem. Cash also can make sense as part of a defensive strategy during a bear market (typically a lasting market downturn of -20% or more due to an identifiable fundamental cause), perhaps alongside bonds and other securities, depending on market conditions. However, we think it makes sense to go this route only if you see a bear market forming and have based your assessment on careful fundamental analysis, not merely recent returns. In our view, the reasons we have seen in financial headlines for raising cash now seem less beneficial. A common rationale we have observed: Recent volatility is a call to pare back share holdings to protect capital whilst also building up some opportunistic cash reserves to invest after a decline.
Whilst that reasoning may sound nice in theory, it falls apart in practice, based on our experience. Our research shows volatility doesn’t announce its arrival or departure, and a short negative spell doesn’t automatically beget more market bounciness. As we wrote last month, markets had been relatively calm in 2021—until September.[ii] But last month’s dip doesn’t say anything about future market movement, in our view. Yes, more negative volatility is always possible, and if equities fall anew, the calls we have seen to hold cash for future buying opportunities could look prescient. But volatility goes both ways. If markets go through a stretch of positive volatility, that better buying opportunity you are waiting for may be in the rearview already.
Our study of market history reveals the returns investors would have missed if they exited at the start of a pullback (a decline from a prior high) or correction (a sharp, sentiment-driven downturn of about -10% to -20%) and remained out of shares for the rest of the bull market’s duration. (A bull market is a long period of rising stock prices.) Those potential missed returns from not being invested in stocks are also known as opportunity cost.
Take the 1990s bull market, which lasted from October 1990 – September 2000.[iii] Global shares suffered a bout of negative volatility in late 1997, falling -13.8% from 12 August – 12 November.[iv] If an investor exited markets on 12 August—thereby avoiding that downturn—but failed to return to stocks for the rest of the bull market, their missed returns would have been 64.0%.[v] In 1998, global shares suffered an even larger downturn in a shorter period of time, falling -17.9% from 17 August to 29 September.[vi] An investor who left shares on 17 August would have missed that downturn, but if they didn’t get back into stocks for the rest of the bull market, their missed returns would have been 50.4%.[vii] In our view, this illustrates a broader point: being out of markets to dodge volatility can come with a big opportunity cost.
The bull market from March 2009 – February 2020 has examples in which attempting to miss short-term volatility would have been costly, too.[viii] See 2018, which featured a couple periods of sharp negative volatility. From 19 January – 23 March, global shares dipped -9.4%.[ix] If an investor exited markets on 19 January and didn’t reenter for the rest of the bull market, their missed returns would have been 22.7%.[x] Later in 2018, global markets fell even more sharply, falling -16.3% from 28 August – 25 December.[xi] The investor who left shares on 28 August and didn’t return for the rest of the bull market would have missed returns of 13.9%.[xii]
Now, a bear market did strike within two months of 2019’s end.[xiii] For investors who had loads of cash, this was a fantastic buying opportunity. But we strongly doubt too many people with cash reserves meant for this kind of moment were rushing to deploy it in mid-March 2020—the bear market’s end—as pessimism and fear of a new depression reigned, based on headlines we followed.[xiv] Instead, we saw lots of commentators arguing for months and months thereafter that the new bull market was disconnected from a dire reality—and sure to reverse before long.[xv]
That brings us to a critical point: If you up your cash holdings with the intent of deploying them at a better time, you also have to determine when to buy back in. With hindsight and past market data, the ideal reentry point—i.e., a market trough—looks obvious. But in the moment, many investors attempting to time the market fail to do so, in our experience. We have found stocks are the rare thing people tend not to want to buy when they are on sale. Our research shows sentiment is usually dour following a market decline, and it gets more so the further shares fall. Hence, many investors tend to seek confirmation the worst has passed before acting, in our experience. Yet stocks don’t sound an all-clear signal, and those waiting for one may end up missing the very buying opportunity they were waiting for. In our view, enduring those volatile days, weeks or months helps mitigate the risk of missing a bull market’s returns over the longer run.
Again, if you see an actual bear market forming, it can make sense to reduce your equity exposure significantly. Those declines are typically long, deeper than -20% and grinding. Our research shows they begin and end for fundamental reasons, so if you are careful and disciplined, we think investors can mitigate the risk of missing the sharp rebound that usually characterises new bull markets. That isn’t the case with corrections or pullbacks, which we have found are sentiment-driven. That is why they defy predictability—sheer irrationality at work, in our view. They are also normal during bull markets. Yet history suggests those unpredictable pullbacks and corrections needn’t derail shares’ long-term returns. Take America’s S&P 500, which we cite here for its 90-year dataset. During bull markets, the S&P 500’s average annualised return in US dollars is 21%.[xvi] To us, that is the reward for dealing with volatility.
Rather than get hung up on the prospect of near-term dips, we think investors benefit more from taking a higher-level view and focusing on market cycles. As Fisher Investments founder and Executive Chairman Ken Fisher has said, “If you aren’t in a bear market, you are in a bull market.” We think investors who need long-term growth must participate fully in bull markets to reap their gains, which includes enduring a lot of uncomfortable volatility. To instill discipline, we suggest investors reframe how they treat market pullbacks. Rather than as a call to action, view them as the price to pay for bull markets’ long-term returns.
[i] Source: FactSet, as of 25/10/2021. MSCI World Index return with net dividends, in GBP, 6/9/2021 – 4/10/2021 and 6/9/2021 – 22/10/2021
[ii] Source: FactSet, as of 21/10/2021. Statement based on MSCI World Index return with net dividends, in GBP, 31/12/2020 – 20/10/2021.
[iii] Source: FactSet, as of 21/10/2021. Statement based on MSCI World Index returns with net dividends, in GBP, 31/10/1990 – 18/9/2000. Monthly returns used from 31/10/1990 – 31/5/1994 in lieu of daily returns due to data availability.
[iv] Ibid. MSCI World Index returns with net dividends, in GBP, 12/8/1997 – 12/11/1997.
[v] Ibid. MSCI World Index returns with net dividends, in GBP, 12/8/1997 – 18/9/2000.
[vi] Ibid. MSCI World Index return with net dividends, in GBP, 17/8/1998 – 29/9/1998.
[vii] Ibid. MSCI World Index return with net dividends, in GBP, 17/8/1998 – 18/9/2000.
[viii] Ibid. Statement based on MSCI World Index return with net dividends, in GBP, 6/3/2009 – 20/2/2020.
[ix] Ibid. MSCI World Index return with net dividends, in GBP, 19/1/2018 – 23/3/2018.
[x] Ibid. MSCI World Index return with net dividends, in GBP, 19/1/2018 – 20/2/2020.
[xi] Ibid. MSCI World Index return with net dividends, in GBP, 28/8/2018 – 25/12/2018.
[xii] Ibid. MSCI World Index return with net dividends, in GBP, 28/8/2018 – 20/2/2020.
[xiii] Ibid. Statement based on MSCI World Index return with net dividends, in GBP, 20/2/2020 – 16/3/2020.
[xiv] Ibid. Statement based on MSCI World Index return with net dividends, in GBP, 20/2/2020 – 16/3/2020.
[xv] Ibid. Statement based on bull market in MSCI World Index beginning on 16/3/2020.
[xvi] Source: Global Financial Data, as of 29/7/2021. Statement based on S&P 500 Price Index bull markets, in US dollars, 1/6/1932 – 19/2/2020. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
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