Global stock markets are plummeting Friday in the wake of the U.K. vote to leave the European Union. What's a regular investor to do at such a turbulent and potentially frightening time for the markets?
Well, the best advice might have come from my 11-year-old son, Jack, last summer. It was a day when the Dow Jones Industrial Average dropped 530 points.
Talking about his sailing class that day, he said, "Daddy, today the wind was strong and it was a little scary at first. I remembered what my teachers said, though, kept calm and just stayed on course."
It's the same when markets are volatile. Avoid making sudden changes based on fear. Make sure you have a solid long-term plan (emphasis on "long-term") that is prudently diversified and designed to meet your goals, not the investment models of others.
Try to remember that investing should be a means to an end, not a competition. Try to stay anchored on your plan vs. getting caught up in day-to-day events. This is difficult, by the way, and many investors make poor decisions at the wrong time.
Morningstar in 2014 published a report that looked at the difference between the average return of mutual funds and the actual returns fund investors got. To find the actual returns, the researchers adjust for inflows and outflows of money to/from the funds. They also asset-weighted investor returns. What they found was startling. The average 10-year total return for U.S. equity funds for the period ended Dec. 31, 2013 was 8.2%, but the average return of investors in such funds was only 6.5%. For all types of mutual funds, the average 10-year total return was 7.3% while the investor return was only 4.8%.
Clearly, investors were getting into and out of funds at the wrong moments.
"Over the past 10 years, flows were headed in the wrong direction at a couple of key junctures," wrote Russel Kinnel at Morningstar. "In 2009, money flew out of stock funds, but that proved to be the bottom of the market and a great spot to get in. Some investors were also leaning the wrong way in 2012 and 2013."
If you believe that this 10-year period was an outlier, you might want to look at a report from the institutional investment consultant DALBAR. It showed that investors have underperformed the market by approximately 4.2 percentage points per year over the past 20 years.
"The report has focused on the fact that in addition to availability and need for cash, the major cause of the shortfall has been withdrawing from investments at low points and buying at market highs," DALBAR said in announcing the results.
So what specifically can we do to become better investors and avoid pulling our money out of the market at the wrong time? We don't know what the next few days, weeks or months will bring because of Brexit, but here are a few simple recommendations:
1. Have a Long-Term Plan Designed to Meet Your Individual Goals
- Investing should not be a competition.
- Unless your goals have changed, do not throw out a good plan with a bad market.
2. Set Maximum and Minimum Ranges for Various Types of Investments
- Everyone will be wrong from time to time.
- Set limits on the upside and downside before you invest.
- Maximum and minimum ranges should help to control emotions and hence risk.
3. Try to Think Outside the Box and Consider Being Contrarian
- Wall Street predictions are often wrong (see "Should You Treat Wall Street Forecasts Like April Fool's Day Jokes?")
4. Place a Premium on Liquidity
- Don't invest in illiquid investments unless the rewards being offered are compelling.
- Don't blithely pay higher fees for lower liquidity.
- Carefully evaluate return and risk opportunities being offered when taking on illiquidity.
5. Understand True Risk Exposures of All Investments
- High-yield and emerging-market bonds and distressed debt don't have the same risk as other bonds.
- Fancy alternative strategies based on complex models and investment theories may not hold up when you need them the most (remember Long-Term Capital).
6. Remember Taxes and Fees
- Keep-it-simple, low-fee investments often outperform (see the "Say It Ain't So, Joe" commentary on active funds vs. index strategies).
- Complex hedge funds that promise high returns or downside protection are often very tax inefficient (see our "What Would Yale Do If It Was Taxable" piece on how index funds are often more appropriate for taxable investors).
7. Don't Be Sold
- If you don't fully understand it, don't buy it.
- Always ask for complete transparency on all fees, risks and conflict.
8. Slow, Steady and Boring Often Wins
- As with many things, the tortoise consistently beats the hare and often with much more peace of mind and less heartburn, which makes it easier to stick to a long-term plan.
As my son learned on the water, conditions are often out of our control and can change rapidly. Be prepared and stay broadly diversified. Don't reach for returns. Keep focused on your long-term plan and don't allow yourself to be sold the hot investment strategy.
Brexit is sure to bring some continued market storms, but remember, history consistently teaches us that true long-term investors ("who will in practice come in for the most criticism," according to John Maynard Keynes) will continue to be rewarded for just keeping calm and carrying on.
See full Brexit coverage here.