Last week was the easy bit. As schoolboy-philosopher Nigel Molesworth might have said, ‘any fule kno’ the stock market goes up and down and bull markets don’t last forever. The harder thing is knowing what to do about it.
Having concluded that the bull market is mature and noted the echoes of 1999, I am now asking myself two sets of questions. The first addresses what I can learn from history about how to navigate what comes next. The second is more personal - how does this fit with my particular circumstances and psychological make-up.
An interesting piece of analysis from Schroders recently made a well-argued but unsurprising case for doing nothing. Duncan Lamont, head of strategic research, pointed out that, since 1926, the stock market has been at an all-time high in 363 of 1,187 months, 31 per cent of the time. So, fretting about the market simply because it is high makes little sense. Rising over time is what stock markets do.
More interestingly, and surprisingly, he crunched the numbers and concluded that the subsequent returns in the year following a new high are on average a bit better than when the market is not at a new high - 10.4 per cent versus 8.8 per cent. Over longer periods of two and three years, there’s little in it.
Finally, he looked at what would have happened if you had exited the market for a month whenever the market hit a new high and gone back in when it wasn’t at one. Over the long haul, he says, this attempt to time the market would have reduced your total return by a staggering 90 per cent. I’m not sure how realistic this is, but even over shorter periods, jumping in and out of the market can seriously damage your investment performance.
Lamont’s work chimes with plenty of other industry research which, for example, points out that missing the best days in the market through poor market timing significantly reduces your long-term returns. Or that investing for longer periods of time reduces the volatility of your returns (they gravitate towards the long-run average) and reduces the chance of a negative return. Over a sufficiently long investment period (say, 20 years) the chance of losing money is negligible.
A glance at a long-term chart of the stock market suggests that just gritting your teeth and sticking with it through the inevitable ups and downs is not a bad strategy if time is on your side. Even the 50 per cent downturns after the dot.com bubble burst and during the financial crisis look a lot less scary with the benefit of hindsight than they felt at the time.
But history takes no account of the psychology of investing.
And anyone who lived through those downturns knows that few of us have the emotional detachment to accept losing half your money every 25 years as the price we pay for the long-run outperformance of shares.
So, the second set of questions is also important. How will I feel if the value of my portfolio falls by 25 per cent? How confident am I that I can trade in and out of the market in a calm and calculated way? What is my investing timescale? If I am no longer earning and drawing an income from my savings, can I afford a poor sequence of returns? A few bad years then a few good ones will deliver a very different outcome for someone in retirement than a few good ones followed by a few bad ones.
So, the lessons I take from history extend beyond the ‘just stick with it’ bromides. I looked back at the 15 years from the start of 1999 to see what might have actually helped navigate a tricky period in which to be managing a portfolio. If my analysis last week is right, it may provide a plausible template for the next decade and a half.
My first conclusion is that when the market has been as narrowly focused and as stretched as it is today, it has paid to diversify away from the recent winners. I looked at diversification from the perspective of geography, asset class, investment style and sector. However, you cut it, spreading your bets provided a smoother ride and better returns over that period. So, job number one is to say thank you and a partial farewell to big US growth stocks. Cheaper markets like the UK, Europe and Japan will play a more prominent role. Ditto, value-focused funds looking for opportunities in out of favour, more defensive sectors.
My second conclusion follows from the first. If the outperformance of such a big part of the market is coming to an end, tapping into that cheaply and easily through a passive market tracker will no longer be the obvious solution. If investing is about to get more difficult, then it is going to make more sense to pay someone with knowledge and experience to do it for me. Actively managed stock-picking funds had their day between 2000 and 2003, and I expect them to do so again.
Thirdly, while I accept that I may pay a price for the security of cash in terms of lower long-term performance, I’m happy to do so with a proportion of my portfolio. My goal is to never have to worry about what’s happening in the market over the short to medium term. If that means that I need a cash buffer to cover two or three years of reasonable spending, then so be it. With interest rates where they are, it is anyway only a small sacrifice.
Finally, and this matters given my short-term caution, I retain my faith in the creative genius of human nature to find solutions to our problems and generate growth and prosperity. The dogs may be barking, but the caravan rolls on.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
