There are always frightening stock market moments and temporary jump scares for investors. We just recently lived through some of them a little over a year ago. But when you invest for the long-term, you can keep those bumps in the night in perspective and stay smarter, happier, and richer, which is our motto around here.
On this Friday the 13th, when many people proceed with caution, we thought we'd provide some tips on how to avoid the traps that can derail long-term gains.
1. Avoid walking under ladders — and market timing
Just as walking under a ladder is considered a sign of bad luck, trying to time the market can invite misfortune in your portfolio.
A prime example occurred last year at the start of the pandemic when the market lost one-third of its value in the span of about a month. Many investors pulled out of some of their more-volatile stocks in an effort to cut their losses, but what they probably did was lock in their losses and thwart their gains on the rebound. At the low point back on March 16, 2020, the S&P 500 was around 2,300; Now, almost a year and a half later, it's over 4,400. I'm no math major, but that's almost double.
A recent study by the American Association of Individual Investors showed just how tough it is to time the market. Looking at the period from 2000 to the end of April 2020, seven of the best days on the market occurred within a week of one of the 10 worst days. And seven of the 10 worst days were followed the next day by a top-10 day for that year.
Furthermore, a report from HBKS Wealth Advisors says that seven of the best days over the past decade came during bear markets.
Another hazard of timing the market is doing the opposite of buying low and selling high. While many see recessions as a great buying opportunity to get great stocks at low prices, all too often investors do the opposite. They see a stock surge, like AMC Entertainment Holdings, to take an extreme example, only to jump on board when it's near its highs. They not only missed out on the gains, but also got left holding the bag when it plunged back down.
2. Practice sound umbrella management — and diversification
I never understood why it's considered bad luck to open an umbrella indoors. Why would you wait to open an umbrella until you got out in the pouring rain? Doesn't that defeat the purpose?
While I question whether wet clothes are the price to pay for staying lucky, I don't question the sound practice of diversification to avoid any long-term blowups in your portfolio.
Diversification is a basic principle of investing. It is the process of holding a range of different investment types in your portfolio that perform differently in various market cycles to lower your overall risk. So, while simply holding an S&P 500 fund might seem somewhat diversified because you are holding a lot of different stocks, they are all large caps, so it's not true diversification.
Rather, it means holding stocks from several different industries, countries, market caps, investment styles, and risk profiles. It also means holding other investments, such as fixed-income instruments, real estate, and commodities.
If you kept all of your portfolio in similar type stocks (say, only large caps, growth funds, or value funds), your portfolio would move in tandem with that part of the market. If you are well diversified, short-term drops in one area should be offset by gains in another area. Of course, there is the threat of over-diversifying, which could hurt your portfolio.
What is the right level of diversification? Value Line Research did a recent study and found that you can be well-diversified and reduce risk with only about four or five different funds or 15 to 20 different stocks. But even if you have fewer than that, it's important to make sure that they are diversified by industry, investment styles, market caps, etc.
Over the past year, the value of diversification has been clear as growth funds significantly outperformed value funds last year. But through the first six months of 2021, value has beaten growth by a significant margin, according to data from Morningstar. Furthermore, small caps have outperformed large caps during the recovery.
So if you have a case of triskaidekaphobia (fear of the number 13), I hope this article has made it clear that I can't help you. But if you follow these two basic principles of investing, you'll reduce the chances of being haunted by a portfolio that underperforms in the long term.
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