When markets fall, do not panic and sell. In fact, do exactly the opposite. Buy on the dip, as they say. Or, at least, hold your nerve.
Fiscal View: Perseverance pays off as equity markets surge
Not a lot has happened this week. The most stimulating activity for me was a late night telephone call from my son at Bristol University, who was struggling to understand the sequential nature of mathematical differentiation where the independent variable is, in fact, a function of a third variable.
Through the miracle of Skype, we could see one another's feeble mathematical jottings to address this aspect of calculus. And it got very exciting as we gravitated, father and son, to a solution of pure mathematical elegance.
Oh, and yes, there was something else that happened - October has witnessed (or, more than likely, will witness) the largest monthly growth rate in equity markets for 21 years in the UK and 37 years in the US.
So those of you who followed my advice and held your nerves, did not panic and, more importantly, did not sell your equities or equity funds when they slumped in the summer, have been richly rewarded. Or, to be more precise, have nearly recovered their losses. Those of you who invested cash when the markets were decimated a few months ago have done extraordinarily well.
The FTSE 100 index was up by an amazing 11.2 per cent for the month of October, finishing at 5,702 on Friday, October 28. The last time this kind of monthly performance occurred was more than 20 years ago, in May 1990, when the FTSE 100 index leapt 11.5 per cent.
Only a few days before October 28, the FTSE 100 finished its third quarter down by 13.7 per cent - its worst quarterly performance in nine years after a wretched summer of discontent over sovereign debt in the US and Europe.
But last month, the mood among investors changed significantly with strengthening data on US retail sales, improving economic growth in the US and growing hopes of a solution to the euro zone's debt crisis.
Markets in the US enjoyed similar performances, with the S&P 500 heading for its best month since 1974 with a 13.3 per cent monthly gain for October.
The lesson to be learnt here is that equity markets suffer enormously from short-term volatility but the significance of this, from an investment point of view, is relatively small providing you are in it for the long term. When markets fall, do not panic and sell. In fact, do exactly the opposite. Buy on the dip, as they say. Or, at least, hold your nerve.
Blackrock, the UK-based fund management group, has published an excellent study on these issues (Weathering Uncertain Markets) and gives the following advice:
• Market upturns, in general, tend to last longer than downturns and add more value;
• Investors who jump in and out of markets run the risk of missing the best high-performing days;
• Although markets are volatile in the short term, over time they tend to produce strong results;
• Investing in a broad range of asset classes and investment styles can help reduce risk;
• Investing regularly can help to smooth out the effects of short-term volatility; and
• Periodic rebalancing of your portfolio is needed to ensure that you stay on track.
Of particular interest is Blackrock's analysis of market upturns and downturns. Over the past 80 years, Blackrock identified 15 downturns that lasted an average of 13 months and resulted in an average market loss of 28.4 per cent. These were followed by upturns that lasted an average of 55 months and generated 191.9 per cent growth. With the exception of one instance, the minimum recovery period lasted 24 months.
So on this basis, investors should hang on to equities for at least two years and probably much longer.
This advice would be easier to take on board if we could believe that Blackrock's 80-year analysis is relevant to the past 10 years, where equity markets have been abysmal and, more importantly, to the next 10 years.
Its answer to this is to diversify your portfolio. It is true that equity markets, as represented by the S&P 500, have performed badly over the past 10 years. But this is not true of all asset classes. Corporate bonds, high-yield bonds, Asian/emerging market debt and equity, small- and medium-sized company equities and certain types of hedge funds, have all had their periods of glory over the past decade.
If your portfolio is sufficiently diversified and includes these types of assets, then it will have weathered the equity storm and will now be poised for growth.
Another interesting part of the Blackrock report analyses the importance of missed opportunities. Remaining invested is crucial because when growth occurs, it can often occur over a period of just a few days. If you are out of the market when this happens, pondering the best time to jump back in, you are likely to miss it.
A hypothetical US$100,000 (Dh367,310) invested in the S&P 500 at the beginning of 1991 would have grown to $575,000 by the end of 2010. If you had missed the five best days in this 20-year period, the portfolio would have grown to only $381,000. That is a staggering 33 per cent reduction in the final value for missing just five days of investment.
Makes you think doesn't it?
Instead of fretting over the day-to-day fluctuations in your portfolio's value, just make sure your asset allocation is appropriate and go to the beach, or the cinema, or on holiday ... anything except dipping in and out of the markets.