You can’t escape the fact that being invested in the stock market involves a degree of risk. But it’s one of the ironies of equity investing that being out of the market is also a risk. In fact, for most people, it’s more of a risk, because it increases the likelihood that, when you want to retire, you won’t have saved enough money to last you for the rest of your life.
In the final part of Conquer Your Fear of the Stock Market, our five-part series for RockWealth, we compare the risk of being in the market with the risk of being out of it.
We’re going to be releasing a full-length version of Conquer Your Fear of the Stock Market. In the meantime, if you’ve missed any of the other videos in the series you can catch up here:
Conquer Your Fear of the Stock Market, Part 1
Conquer Your Fear of the Stock Market, Part 2
Conquer Your Fear of the Stock Market, Part 3
Conquer Your Fear of the Stock Market, Part 4
Transcript for Part 5 of Conquer Your fear of the Stock Market
5. The biggest risk is being out of the market
One of the ironies of investing is that a bigger risk than being exposed to the stock market is NOT being exposed to the stock market.
When markets are volatile, or when there appears to be no end in sight to a long bear market, some investors choose to take risk off the table. Some abandon equities altogether. But it can be a dangerous strategy.
Financial author Jason Butler says: “The problem about making the decision to come out of the market, or not be in the market, is that you’ve got to then make a decision when to go back into it. So, in other words, you’ve got two decisions to make, whether it’s omission or commission. So whether it’s an act of omission – not doing something – or commission – of doing something; you then have to decide when to do the alternative.
A common feature of market bottoms is that once the lowest point has been reached, prices can start recovering very quickly. Some of the best days for equity returns come at the very start of a bull market.
Professor Jens Hangendorff from Univeristy of Edinburgh Business School says: “The risk of missing the best days is very large, simply because a few trading days make up a very large percentage of overall gains over long time periods. Traders that I talk to often use the rule of thumb that something like the best trading days over a long period make up half of their entire returns. So if you miss out any of those, you will have missed out on quite a proportion of your overall gains, and since you cannot time the market with a reasonable degree of precision, you are very likely to lose out on the best trading days if you try to do that.
Professor Janette Rutterford from the Open University Business School says: “Good days can be very good. They could be five or ten per cent market movements. That’s not very often, but it could happen. So if you go away and you miss ten or 15 per cent, then that’s extremely bad – and then might go back in just as it collapses. You can’t tell, but it’s just adding an extra level of risk to your investment strategy, which is not worth taking.”
And there’s another important reason why you should stay invested. The longer you’re in the market for, the more you will benefit from the effects of compounding.
Financial author Andrew Craig says: “ Compound interest is where you take £1000, let’s say – and you make ten per cent in over, let’s say, one year. So, at the end of the year, you have £1100. If you do that again: the following year you make £110 of return. So you’ve got £1210. And crucially, that £10 is the return on your return; and that is the beginning of compounding. So compounding, to me, just means the return on your return; and what that means to any mathematician is a geometric progression – it means that the curve becomes steeper over time, and the return on your return becomes more. Most people think: “so, I make £1100 on £1000 in year one, and £1210 in year two… big whoop! What does that actually mean?” But the numbers, over time, get extremely big and are extremely powerful. Compound interest is probably the number one reason why anyone becomes really, really wealthy over time. Warren Buffett talks about the fact that he’s made over 90 per cent of his wealth since his 60th birthday, because the curve gets so much steeper. Obviously, ten per cent on a million pounds, in absolute numbers, is an awful lot more than ten per cent on £1000. That’s obvious, but that’s why the effects are so powerful.”
So, to return to that JENGA analogy we used earlier, just hold your nerve. Yes, the tower will fall from time to time But you need to stay in the game. It’ s not fear that’s rewarded in the equity markets; it’s courage.
Picture: Lisa H via Unsplash
