Once you get a realistic understanding of what to expect from your investment return, you’re better prepared to face the next challenge the market throws at investors: dealing with its ups and downs.
Knowing the expected average return of a particular asset class isn’t particularly helpful when you find yourself on this roller-coaster ride. For most people, hearing that stocks average a 4.8% return over the long run is quite unhelpful during a period of time when the market keeps going down.
How Recency Bias Can Get in the Way of a Positive Investing Outcome
We can thank something called recency bias for this. Recency bias is the tendency to think that whatever happened in the immediate past will continue long into the future.
It doesn’t matter what the long-term average is, in other words, to someone with a portfolio that just dropped 15% and is now looking at a whole lot of red. Most people can’t think rationally and logically enough to get through that period of time.
They panic instead of being patient because they feel like it’s never going to get better and it can only get worse. They let their emotions get the best of them and end up selling out of the market.
The mistakes only continue from here. What an investor like this has just done is sell low, and they will most likely wait until the market has absolutely, definitely improved before they jump back in… at which point they’ll buy high.
This is literally the opposite of what you need to do as an investor.
What can help you avoid this unfortunate situation and negative investing experience is to prepare yourself to ride out those ups and downs that we know will happen on your way to a long-term investment goals.
First, Understand That Market Ups and Downs Are Normal
The market tends to be cyclical, with periods of expansions followed by periods of decline -- until the cycle starts again and things trend upward.
We know the market usually moves like this. What we don’t know is when it will move either up or down. But that’s okay! We don’t need to know that.
All we need to know is to expect ups and downs. This chart can help show you how this has always happened in the market in the past:
This chart outlines some of the generally-accepted descriptions of these large movements, both the upswings and the declines. For now, let’s focus on the declines since downward movement is the kind that concerns most people.
Here’s some of the most important points this data makes:
● In 56 of the 71 years of this study, there was a decline between 5-9.9%, with an average drop of 7%, lasting one month and then taking 2 months to get back you to even.
● In 21 of the 71 years, (roughly once every 3 years) there was a decline between 10-19.9%, with an average drop of 14% lasting 5 months and an average of 4 months to recovery.
Let’s take a closer look at that second point. It tells us that about every 3 years, the market will drop on average 14% over a 5 month period. When that drop is complete, it will take another 4 months, on average, to come back.
What I suggest that you take away from this is that markets do fall. And they tend to recover. Over time, that recovery has only taken a few months -- so it’s well worth staying calm, learning to accept that ups and downs are a normal part of investing in the market, and staying in your seat.
Conclusion: Stay in Your Seat!
The market will rise and fall. And that’s okay! It’s not always supposed to go up -- but you are supposed to stay calm and not let your emotions in the moment get the best of you.
Remember to focus on what you can actually control (which is not market movement).
Don’t twiddle with your portfolio (especially when you’re feeling emotional). Make sure your investment decisions are not based upon market drops (or increases). Don’t try to time the market. Create an investment strategy based on your needs and goals -- and then stick to it!