When there's some downbeat economic or market news, it's no surprise that some investors may end up fleeing the market for what they believe is safety or keep their cash on the sidelines until it's clearer which way things may be headed.
Unfortunately, they may be undermining their long-term growth potential. "In my experience, disciplined investors who develop a financial plan and stay invested have typically had better success reaching their long-term-financial goals," says Naveen Malwal, an institutional portfolio manager with Strategic Advisers, LLC. "I have found that investors who keep waiting for the perfect time to invest often miss out on gains over time."
While uncertainty, volatility, and recessions can be disruptive and disconcerting, when we look at historical trends, few economic events could be as damaging to the long-term growth of your portfolio than allowing fear to cloud your judgment.
The potential danger of reactive decision-making
Over the last 30 years, studies have shown that when investors have given up on their long-term strategies and react to short-term developments in the market, their portfolios have suffered.1 Reactive behavior on the part of an investor can be a significant drag on performance. For example, since 1992, the average equity fund investor has underperformed the S&P 500 index, largely due to investor attempts to time the market. In 2022, for example, the average equity fund investor underperformed the S&P 500 by just over 3%.2
Part of the reason for this underperformance may be that investors might have an outsized impression of the impact that bear markets, volatility, and recessions may have on the long-term health of their portfolios. By making reactive or emotional decisions without the historical context, they may end up hurting their long-term growth prospects more than if they had simply ridden out the storm.
Putting the market environment into context
Consider the following reasons why an investor might be wary of investing when markets are volatile:
1. I'm worried about declines.
It's entirely possible that markets could decline. However, if you look back at previous bear markets, you'll see that staying out of the market could result in missing out on a potential recovery. Since 1950, stock market recoveries have often started soon after the bear market began, recovering a median of 7% during the rest of the same calendar year. Returns in the following years have historically shown even more promising results. Trying to time the market in an attempt to avoid losses or catch a rally is difficult or even impossible. It can often be a better idea to just get invested and stay focused on your long-term goals.
*Year occurred during a recession, as defined by the National Bureau of Economic Research (NBER), as of 2/5/2024.
2. I don't want to invest during the late part of the business cycle because I expect a recession to follow.
Being picky about when to enter the market based on where we believe the US economy is in the business cycle is unlikely to dramatically affect returns. When looking at investments made at different stages of the business cycle, the difference in average long-term performance has been very small over time.
For illustrative purposes only. Past performance is no guarantee of future results. It is not possible to invest directly in an index. All indexes are unmanaged. Sample portfolio: 36% US stocks, 24% international stocks, 40% IG bonds. See disclosures for index definitions. This historical analysis is based on Monte Carlo analysis based on historical index returns. "Range of expected returns" illustrates simulations between the 25th and 75th percentile. The simulations represent an 85% confidence interval. Actual returns could potentially be higher or lower. Portfolio based on Dow Jones US Total Stock Market Index, MSCI ACWI ex-US Index, Bloomberg US Aggregate Bond Index, as of 12/31/2023.
Additionally, while recessions are certainly stressful and can present significant challenges to investors, they have often been relatively short and, historically, have been followed by larger, longer expansionary periods in which stocks have seen gains. "Since 1950, the US has gone through 11 recessions and many other challenges," says Malwal. "But stocks have finished higher than where they started in 5 out of 11 of those recessions. So not all recessions have led to stock market declines. And stocks have experienced about 15% annual returns since 1950, despite multiple setbacks over time."
3. I feel safer with my money in cash
While keeping your money in cash may seem like a wise decision when uncertainty is high and markets are unpredictable, the sense that it's risk free is somewhat of an illusion. Though your account balance may appear stable, inflation can eat away at its value over time, reducing your purchasing power. Furthermore, cash has historically tended to meaningfully underperform stocks and bonds when the Federal Reserve has stopped hiking interest rates. On average, stocks, bonds, and a diversified portfolio have outpaced cash as soon as 1 year after rate hikes end.
Maintaining composure is key
Understanding the relative effects that recessions, volatility, bear markets, and investor behavior have had on portfolios is a key component to making more informed decisions about when and how to invest. However, even this knowledge may not be enough to assuage investor anxiety when the market declines and portfolios suffer. Thankfully, there are methods available to help investors avoid reactive decision-making.
- Make sure you have an emergency fund. Knowing you have enough money on hand to cover your essential expenses and any unexpected needs that might crop up in the event of an emergency can help give you the confidence to let your long-term investments remain in the market. (Learn more about establishing and maintaining your emergency fund.)
- Consider dollar-cost averaging. Instead of investing large sums of money all at once, dollar-cost averaging involves investing a portion of that sum on a regular schedule, perhaps monthly, regardless of what direction the market is heading in. Over time, this may help you purchase more shares when prices are lower. (Learn more about dollar-cost averaging during bear markets.)
- Consider investing defensively. Some economic sectors have been particularly resilient in down markets, especially those that offer essential goods and services, such as utilities, health care, and consumer staples. While past performance is never indicative of future results, investing in defensive sectors such as these can help investors feel prepared for what may come. (Learn more about defensive investing.)
- Explore a professionally managed account. With a managed account, investment professionals can help tailor a diversified portfolio in accordance with your goals and risk tolerance. These professionals manage your account based on these preferences and in accordance with a disciplined process of investing and asset allocation that helps to remove emotional or reactive decision-making from the equation. There are different types of professionally managed accounts, but all are geared toward providing you with the information, expertise, and resources to help stay on track during difficult market conditions. (Learn more about professionally managed accounts.)