Matt explains how volatility and uncertainty are the price you pay for higher returns. Here's how to endure them.
May 22, 2021
Domestic stocks have given investors the best returns over the long term, but market sell-offs happen regularly. Since 1928, S&P 500 corrections – defined as drawdowns of at least 10% – have occurred a little more than once per year, though since World War 2, that average has dropped to about once every 18 months.
In other words, corrections are expected in the stock market; the volatility and uncertainty are literally the price investors pay for higher returns. Selling while the market is choppy locks in losses and can erase years of compounding at the worst possible moment. If investors do not know how to endure these drawdowns without panic-selling at low prices, they will have a hard time making money in investing, much less beating the market.
To help you endure these moments of stomach-churning volatility, here are a few tips that have helped me in the past.
Recognize volatility is normal. Again, as mentioned above, corrections happen regularly. Bear markets, defined as drawdowns of at least 20%, only occur slightly less often, about once every 56 months, or every four years and eight months. Look at your portfolio’s value and realize that number will fall by 20% or more every few years. Knowing these are regular occurrences and not the end of the world can help you mentally prepare for them.
Investing will often feel like a frustrating journey. While stocks return about 10% annually on average, they rarely return that in any given calendar year. Instead, it’s a journey characterized by jumps, starts, and setbacks. For every three steps forward, it can be two steps back. Accept and understand this, and you’ll be much better mentally and psychologically prepared to handle the inevitable drawdowns in your future.
Develop a thesis for every stock you own. In other words, know why you own what you own. Knowledge is power. As we state in our seventh principle:
“Write out exactly why you’re investing in a company and the specific things that will tell you if it’s doing well or poorly. The more quantitative and company-specific, the better. Use this as the standard to objectively evaluate the business when its stock price is falling. If the buy thesis is still intact, it will let you hold or even add with confidence during these drops.”
Don’t use options and margin. Using options and margin can seem like a no-brainer during a bull market. After all, why not juice your returns? However, when bear markets come, using these financial instruments can turn what would have been temporary paper losses into actual losses. You don’t need to add more stress to investing by using these tools.
Finally, and most importantly, invest with the proper time frame in mind. No money should be invested in the stock market that might be needed in the next 3-5 years. Remember, investing is a long-term pursuit of wealth, not a trip to a casino. It’s not meant to make you a millionaire overnight. Just build wealth slowly over a long time.
When Amazon founder and CEO Jeff Bezos once asked Warren Buffett why more people didn’t follow his method for building wealth, Buffett replied, “Because no one wants to get rich slow.”
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