Humility and resolve are allies of long-term investors

In many endeavors, it is easy to make comparisons that lead to an informed choice. As consumers, we do this all the time. We evaluate not only the cost of a consumer good, but also the difference in price per ounce for the large versus small size. Beyond the day to day purchases we make, we make assessments of things like hotel chains, airlines, and auto manufacturers. With respect to sports teams, track records can be a strong indicator of things to come. While the unexpected happens from time to time (e.g., Vanderbilt’s upset of Alabama in football this year), it can be relatively easy to evaluate the teams and come up with a reasonable analysis of the likely winner, before the game starts. It gets more difficult to win, when you have to cover ‘the points spread’ in order to win the wager. That’s because injuries of key players or unusual ‘turnovers,’ can affect the outcome. The same is true for investment in stocks. Unforeseen events can result in sharp reversals up or down.

After prolonged periods of rising or falling security prices, it is relatively easy to expect the trend will continue. It often does, but nothing lasts forever. When the S&P and NASDAQ advanced sharply in the mid-1990s thru early 2000, it sure seemed like the market would continue to post strong gains. Then unexpectedly, the S&P 500 and NASDAQ lost 50% and 80% of their price in the epic bear market of early 2000 thru late 2002. In hindsight, we now know that while conditions in the economy were favorable during the sharp rise, things like the PE ratio became unsustainably high. At the bottom of the ensuing bear market, valuations metrics fell to relatively low levels compared to history. Investors who paid attention to valuation metrics and less to the comforting and then disconcerting news, were better able to maintain perspective. This enabled them to avoid the temptation of being ‘all-in’ at the top in the most expensive stocks or largely out at what proved to be the bottom. That is why we assess things like valuation metrics, investor sentiment and other inputs and incorporate them into our decision process. Stretching our time horizon helps us to stay the course when others are caught completely offsides.

Riding the wave higher is exhilarating while seeing the value of one’s life savings plummet can be terrifying. At extremes, emotions can lead many to believe that price changes are the only thing they need to focus on. We are certain that taking a long-term view and evaluating if valuations are either near historical highs or lows is a better input to making rational decisions. While sirens and bells do not ring at market tops and bottoms, thoughtful consideration of what could go wrong in ebullient times and what could improve during times of duress can be beneficial.

Security prices can and often do travel far from low to high and vice versa. Many investors seem to see a trend and conclude that because all the news is good during ebullient times or bad during periods of declines that the trend is destined to continue. While we acknowledge that the pendulum can swing far, we also appreciate the tendency to swing decisively the other way. Furthermore, careful consideration of valuation metrics doesn’t translate into the ability to know when trends will reverse, but it can help keep emotions in check relative to a focus on price change alone. It is a central underpinning of what we do in our quest to help you both protect and grow your investment capital over time.

It is not if we will experience downturns, but when, and for how long. Investors need to be prepared mentally and emotionally for them so that they act rationally and avoid the temptation of moving out of and then staying out for a long-time. Missing the upside can be as harmful as the declines we experience along the way. Our approach to making it easier to survive the lean times is to hold ‘rainy day reserves’ (e.g. hold allocations in things like money markets and high quality, shorter duration bonds). They tend to provide a source of ballast when equity markets decline sharply. Ownership of less volatile assets is sensible for most investors – especially those who have a need to take periodic distributions from their portfolios to support their lifestyles. The other nice thing about rainy day funds is that they can be used to buy equities when prices are down sharply. This is particularly true for investors who have the ability and willingness to add to their portfolios.

It is easy to stay invested when markets are performing well. The hard part is staying committed to the long-term when markets perform poorly, headwinds are known, and the outlook is disconcerting or worse. However, that’s precisely when the opportunities to buy low are present. You emotionally may want to sell, but logically if you believe that ‘this too shall pass,’ you can stay the course or even add to positions.

We don’t know when the lean, let alone scary times will occur, but we are confident they will. We also have confidence that they will eventually work out and that owners of risky assets like major stock market segments (different than each and every stock) will perform well over the long-term. As I have shared before, if you like competing products ‘A’ and ‘B’ equally well and one is on sale, you will buy the one that is on sale. Investors should use this same process. That is why we have a strong tendency to take positions when headlines and emotions suggest – ‘it is bad and destined to get worse.’ That may be true, but we have confidence that buying securities that have fallen sharply in the context of a bear market tends to foster favorable outcomes over a multi-year period.

If history is a guide (and we believe it is), setbacks including wrenching bear markets are a given, but they are ultimately temporary. That ‘temporary period’ can be a significant number of years, but ultimately, our species is hard wired to persevere and overcome obstacles. We are collectively (not necessarily individually) innately driven to improve our well-being. We do so by inventing better ways to do things (less brawn more brain). We save for tomorrow versus consuming everything today. The improvements in life that occur over years, decades and centuries are something to behold. That said, ‘buy and hold’ doesn’t work all the time. There are extended periods of economic decline (due to wars or policy errors) that translate into low GDP growth and poor returns in the stock market. These same setbacks tend to pave the way for sustained periods of recovery and vice versa. When and where those inflection points lie is largely unknowable and head fakes are common. That’s why we believe the best approach is simply to develop a long-term approach and then largely stay the course.

History reveals that the opportunity cost of being out of the equity markets during favorable times can be more costly than the impact of the market declines themselves. That’s due to the propensity for markets to go up many-fold over decades versus the oft painful declines of 20, 30, 50% or more that also occur. Over the course of my career, I have witnessed a handful of investors sell out near what proves to be the bottom of a particular market downturn. They did so due to fear of more downside. While that is always a possibility, I have witnessed an inability of investors to own stocks when their prices rise significantly above where they sold. Recent examples include the Covid sharp sell-off as well as the sharp declines (especially in high valuation ‘growth’ stocks), when the FED rose rates sharply in 2022. Markets serve up surprises frequently. It is difficult to snuff out and adroitly time selling out or buying in. Markets swing more broadly than the underlying fundamentals of the economy or the underlying stocks/companies. Undisciplined buyers and sellers can take market levels higher or lower than we might reasonably expect. Outguessing the near term is hard. Focusing on long term fundamentals and valuation metrics can help reduce the impulse to ‘do something.’

In sum, markets move higher and lower than most people, including seasoned investors, imagine they can. Strong gains and favorable news can and does cause many to ‘throw caution to the wind’ and concentrate their holdings in the known winners or sell great businesses at decidedly low prices when headlines and price action are adverse. The economy fluctuates as do corporate earnings. That said both tend to be baby roller coasters compared to the stock market. In theory, there are lots of ways to take short cuts (e.g., to avoid declines and invest in good times). Many investors try this. However, most investors simply do not outperform markets over the long-term. That’s largely because of the tendency to be out of market segments during periods when they surprisingly post gains and vice versa. Instincts and headlines cause many to make poor timing decisions. We do our best to avoid these temptations and largely adopt a long- term view. My experience has been when investors sell at what proves to be at or near a market low (and we only know this in the fullness of time), have a near impossible time buying back in. The GFC (great financial crisis) was a time of challenge for investors. At its closing low of 676 on March 9, 2009, the S&P had declined roughly 50% compared to its high price in October 2007. That broad index closed at just 676 on March 9, 2009. Later that same month it traded as high as 850 and before year-end, it reached 1100. Undoubtedly, some investors who moved to the sidelines near what proved to be its low, missed this significant rebound. Setbacks are to be expected, but they are hard to predict. The best course is often to ignore the very real and alarming news and focus on the long-term. We are comfortable doing so.

Warmest regards,

Richard Jones, CFA
Partner, Harmony Wealth Partners