As we start 2023, many investors are pondering how to deal with markets as we exit one of the more difficult years in financial market history. What made 2022 so tough was the combined declines in both the stock and bond markets, which is quite rare.
There is no doubt we are in unusual times, but the basic formula for long-term success hasn’t changed much and is within your control.
In general, there are three primary ingredients to long-term success in the financial markets: diversification, balance, and your attitude or outlook on markets. Making good decisions regarding the first two ingredients is fairly straightforward. It’s the third ingredient that usually causes investors problems.
Let’s start with diversification and balance because they are easier to implement. In a nutshell, it’s prudent for investors to be fundamentally diversified and balanced. If you’ve done that, you’ve probably done about 90% of what you can do to intelligently manage your money. Diversification and balance are the foundations for a sound portfolio.
These days it’s fairly easy to diversify in both the stock and bond markets. There are numerous index funds designed to track broad-based indices like the S&P 500 for stocks and the U.S. aggregate bond market for bonds. Creating a balance then requires you to decide how much you want in each market.
The appropriate mix of stocks (risk assets) vs. bonds (more stable assets) depends on where each investor is in their financial life and their individual tolerance for risk. The basic point, however, is to consider balancing your investments between riskier investments like stocks and more stable investments like bonds.
Now here comes the hard part. If you were balanced and diversified last year, you probably didn’t have a great year. Investors who followed the fundamentals of what constitutes a prudent portfolio may have seen their portfolios decline by 15% to 20%, depending on how they were allocated.
This is where the third ingredient comes into play. Your attitude and outlook on markets will determine how you respond to this. When investors experience meaningful declines, they often get nervous about the future. They think, what if markets keep going down? What if they don’t recover? Those are all normal concerns, but how you manage those risks will have a big impact on your long-term success.
A key to managing risk in financial markets is to stack the odds of good outcomes in your favor. You do that by being fundamentally diversified and balanced; then, you stick with those decisions through difficult markets. It’s tough to stand by those decisions if you don’t have the right attitude and outlook on markets.
The appropriate attitude or outlook on markets means you need faith in the resiliency of markets. No one can prove that they will recover, and there are no guarantees. Thus, if you don’t have that confidence or faith, you’re likely to buckle when markets swoon. That often leads to selling low and buying back when prices are higher.
But how do you have confidence when things seem like they are falling apart?
The answer is time. Viewing market returns through an appropriate time period is key. If you analyze success over short-term time periods, you are likely to be disappointed.
For instance, over the last five years, the stock market produced a total return of about 50%, even after 2022’s decline. You can choose to focus on the almost 20% decline (as of the time I wrote this column) last year, or the 50% return over the previous five years. On the one hand, it was a bad year. On the other, it was a good five years.
I recently listened to an interview Warren Buffett gave in early 2022. It was over an hour long, and he got several questions about what makes a successful investor. He repeated the same answer he’s given over the decades. He said that to be a successful investor, you need the right outlook on markets. He didn’t say the most important thing is to be great at math, great at understanding company financials, or great at figuring out the economy. He said the most important characteristic of successful investors is to have the right attitude and outlook about markets. That means accepting the volatile nature of markets, which can be severe at times. And accepting the reality of the time horizon generally needed to build wealth: think decades, not days.
If you expect more than the markets can provide in terms of stability and returns over the short term, you are likely to make poor decisions over the long term. You may find this helpful to keep in mind as 2023 might again test your faith in markets.
Charlie Farrell is a partner and managing director at Beacon Pointe Advisors LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified because of changes in the market or economic conditions and may not necessarily come to pass. All investments involve risks, including the loss of principal.
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