With inflation running high, uncertainty around the war in Ukraine, and recession worries rising, many investors are wondering whether it makes sense to take some or all of their money out of the market and wait until the economic storms pass.
But while that might seem like a smart move if the markets continue to drop, even a short-term move to the sidelines can hurt your long-term returns and decrease the odds of achieving your financial goals, according to Naveen Malwal, an institutional portfolio manager with Strategic Advisers, LLC. "Historically, we haven't seen a flight to safety pay off," Malwal says. "Despite some challenges investors may see, keeping your assets in cash may be a poor proposition right now." Malwal cites 3 reasons why:
1. Market volatility is normal
Recently both stocks and bond prices have fallen on expectations of rising interest rates and lower growth going forward. But that reflects a deliberate decision on the part of the Federal Reserve to dampen economic growth in order to tamp down rising inflation. "We believe the US economy is still expanding, but in a mature part of the cycle, where the expansion is occurring at a slower rate," says Malwal. And while market corrections can feel scary, they don't necessarily indicate future losses. In fact, double-digit drops are surprisingly common in the stock market - yet the S&P 500 has historically finished most years with a positive return.1 And as the chart below shows, stocks have historically recovered even from major downturns and delivered long-term gains.
Despite market pullbacks, stocks have risen over the long term
2. The best returns often happen when everything feels the worst
Counterintuitive as it may seem, some of the best days in the stock market have historically occurred during bear markets. "What we've seen historically is that investors who give themselves a time out of the market very rarely come back in at the right time," says Malwal. "Negative headlines can persist for some time. Investors typically wait for good news and by the time that happens, they've often missed some of the strongest days of market performance." And missing out on those big days can make a significant difference in your long-term return. As the chart below shows, a hypothetical investor who missed just the best 5 days in the market over the past 4 decades could have reduced their long-term gains by 38%; someone who missed the best 10 days could have undermined their gains by 55%.
Missing out on best days can be costly
Hypothetical growth of $10,000 invested in the S&P 500 Index, January 1, 1980–March 31, 20213
Moreover, many of today's challenges have already been absorbed by the market, according to Malwal, such as the expectation that the Federal Reserve will continue increasing interest rates in order to combat inflation. "When it comes to bonds, our belief is that the worst is now behind us," he adds.
3. Holding cash may also be risky
With recent interest rate increases, yields on relatively safe accounts like money markets and high-yield savings accounts have risen, making them more attractive to savers. But returns on those accounts may barely keep up with inflation in the long run. For example, if an investor puts $100 into a money market account today that returns 4% annually, it would be worth $104 a year later. But at a 4% inflation rate, goods that cost $100 today will cost $104. "Historically, a diversified mix of stocks and bonds have provided a better chance of outpacing inflation over the long run, versus investing in short term instruments," says Malwal.
A better plan of action
Instead of turning to cash, Malwal suggests several moves that can offer protection and diversification in today's market:
- Build in some inflation protection. Within managed client accounts, Strategic Advisers, LLC has been adding some assets that tend to do well in an inflationary environment, including commodities and alternatives.
- Check your bond exposure. Bond prices and yields move in opposite directions. So while rising interest rates tend to depress bond prices, yields have moved higher. Strategic Advisers, LLC has added exposure to investment grade bonds within managed client accounts.
- Assess your tolerance for risk. During bull markets it can be tempting to take on additional risk, but a market downturn is a good opportunity to assess whether your asset mix is well aligned with your risk exposure. "Investors who were tempted to take on more risk over the last few years likely experienced more volatility this year than those investors who regularly rebalanced their accounts," says Malwal. "Greater volatility can lead to more stress for some investors, which unfortunately can lead to rash investment decisions." Regularly rebalancing the mix of investments in your accounts can help keep your risk level consistent in different types of markets. That can help take some of the sting out of future periods of market volatility that will inevitably occur.