Keeping the market in perspective

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As well-balanced, diversified, evidence-based investors, we all know that short term losses are common and part of the weft and warp of growing wealth.

Unfortunately, humans are hard wired to ignore their rational thought processes and to focus in on, and become emotional about, adjustments to share prices. So many still feel uneasy when we see losses on our investments.

It's not unusual: three key behavioural flaws, deeply embedded over millions of years surviving as a species, work against us.

Immediacy
The tendency to focus on something that is happening or has just happened, such as the readjustment of the outlook for global companies given China's slowing of its growth rate.

Anchoring 
The propensity to fixate - or anchor - on a specific reference point, such as the previous high level of the market, portfolio valuation or house price. 

Loss aversion
Where the ratio of downside pain relative to upside pleasure is 2:1. Whilst that kept us alive in our pre-history, it hinders us as investors. 

You can probably spot the problem and the conflation of these three traits when the market falls. Unfortunately newspaper headlines, high profile commentators, the evening news, and irresponsible, headline-grabbing research reports issued by financial institutions amplify the immediacy and pain. We sometimes forget the power of capitalism in creating wealth, and just how ordinary equity market falls are.

Wealth creation stands the test of time

The real (after inflation) growth in GDP provides us with a fair sense of how the world’s wealth has grown. Despite the doom and gloom, the world's GDP growth, after taking account of inflation – for both developed and emerging economies – is estimated to be around 3% for 2016. At this rate (using the Rule of 72), global output would double every 24 years. Real (after inflation) growth in GDP in the UK, from 1948 to 2014, has been a little over 2.5% per annum and today stands at its highest level ever.

The compound (or geometric) return of global developed equities markets from 1970 has been a little under 4% per annum, after inflation. That means that £100 invested in 1970 became £533 of spending power, revealing the power of capitalism to create wealth.

The ordinariness of market falls

Market falls are part and parcel of investing. The more frequently you look at your portfolio, the more likely you are to see a loss, the more pain you will feel, and the more you will fixate on market noise rather than the power of capitalism. If you look weekly, you have an almost one-in-two chance that you will see a loss. In one of the worst weeks, the global equity markets fell by 22%. That is a frequency and magnitude of loss that most investors would find hard to stomach.

Over any one-year period, you would have had a one-in-four chance of a negative return. Don’t expect your portfolio to go up every year; it won’t. Looking every five years reduces the chances of a loss to around one-in-ten.

So what have we learned?

Active investors, who trade frequently, seem to learn nothing from the rollercoaster of the stock market. Sensibly, evidence-based or passive investors know to ignore the hyperbole of media outlets and stop dwelling on the news. They are optimistic about the power of the wealth creation potential of global capitalism, over the time frame they are invested. They don't come to their annual review meeting worried about movements in their portfolio since the previous review.

They know that what matters is whether the value of their assets is still within reasonable expectations, despite being down (or up). Short-term market movements are simply noise and best ignored. 

To find out more about market falls, read Volume 31 of Acuity - Market falls - don't lose your perspective.

Can you trust yourself to be a good investor? Find out in the latest volume of Acuity, now online https://t.co/rCzzrl3nN5