I’m hearing from a lot of people who are worried about uncertainty in the financial markets. It’s affecting their investment decisions.
I get it. Markets are uncertain. Prices are constantly updating based on new information, and new information is inherently unpredictable.
Uncertainty is a normal – even necessary – part of investing, but it becomes a problem when people spend so much time worrying that they miss out on market returns.
The cost of pessimism
Global stocks delivered an annualized 5-per-cent real return measured in U.S. dollars from 1900 through 2022. Data for the Netherlands and Britain back to 1629 and back to 1372 for one French company suggests that a long-term real return of at least 5 per cent has been persistent for hundreds of years.
Based on a carefully constructed sample spanning 38 countries from 1890 to 2019, including failed markets, stocks have also been much less likely to lose purchasing power than bonds and cash at long horizons.
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This should be great news for today’s long-term investors who have increasingly easy access to low-cost diversified portfolios of stocks, but lots of investors are pessimistic about the stock market, and pessimism deters people from investing in stocks.
To be clear, stock markets have been, and will continue to be, volatile. And they are certainly not risk-free in the short run or the long run. Some markets have delivered total losses, while others have delivered low returns for decades.
I may be fuelling pessimism with the acknowledgement that stocks are risky, but here’s the thing: Even accounting for the bad outcomes, long-term, diversified and disciplined investors have typically been rewarded.
The opponent in the mirror
Despite the evidence supporting stocks as sensible long-term investments, investors’ decisions are affected by day-to-day worry. People who check their investments more frequently invest less in stocks and earn lower returns.
It’s common for individual investors to think that the probability of a major market crash is an order of magnitude larger than the actual historical frequency of such events.
The financial media (this column not included) are not helping. The media has an asymmetric effect on crash beliefs. Articles with negative sentiment tend to increase crash beliefs, while those with positive sentiment have no effect.
Expectation errors
When crashes do happen, investors’ expectations of stock market returns become more pessimistic despite the evidence that falling stock prices usually indicate higher expected returns. I find this point incredible – investors’ expectations are inversely related to market expected returns.
Personal experiences also affect how investors form expectations. People who have experienced low stock market returns throughout their lives are less willing to take risk, allocate less of their wealth to stocks and are more pessimistic about future stock returns.
Investing through uncertainty
The biases, influences and errors making investors more pessimistic cause real problems. Pessimistic investors hold more conservative portfolios than an optimistic investor would, avoid participating in the stock market altogether or sabotage their long-term returns with short-term decision-making.
To combat these challenges, here are some suggestions:
- Look at your investments less frequently. People are myopically loss averse, and we know empirically that seeing your investments less frequently is associated with earning higher returns.
- Automate or delegate your portfolio management process. Likely related to investor decision-making, investors lose less of their returns to inopportune investment timing decisions in asset allocation funds, which rebalance automatically, than they do in the underlying equity and bond funds.
- Put what the financial media say in perspective. The financial media often make investors more pessimistic without offering them any useful information. By the time they report on something, that thing is already reflected in prices; media content generally does not contain new information about fundamental asset values.
- Get an outside perspective. Many of these issues are related to base rates. For example, an investor who understands reasonable estimates of long-term expected returns is less likely to worry about short-term market moves.
The expected returns of financial assets are compensation for taking risk, so investing is, by its nature, risky. Investors have benefited greatly from taking risk in the long run, but achieving long-term success means investing through periods of uncertainty.
Benjamin Felix is a portfolio manager and head of research at PWL Capital. He co-hosts the Rational Reminder podcast and has a YouTube channel. He is a CFP® professional and a CFA® charter holder.
