by James Parkyn
When the stock market was falling in February and March, it would have been natural to worry about how bad it was going to get and whether you should cut your losses. It’s at times like those that emotions can cloud your judgment and lead to rash decisions.
But you only have to look at the rapid market recovery in the months following the market decline to understand just how dangerous that kind of short-term thinking can be to your long-term financial health.
If you had bailed out when markets hit bottom on March 23 (after declining 37% in Canada and 35% in the U.S.), you would have missed out on the powerful rally that followed. You would have been left to regret your decision as the market climbed day after day. By the end of June, the market had rallied back 38% in Canada and 40% in the U.S.
To avoid those kinds of mistakes and be successful at investing, you have to give up on the seductive idea that you can outsmart the market. Instead, you have to embrace market pricing where you strive to efficiently capture returns over the long term.
It’s often challenging for smart, successful people to accept that they should aim to earn market returns, especially when the financial industry and the media are constantly telling them they can beat the market.
But consider the difficulties of choosing individual securities, or actively managed funds, that will outperform an index such as the S&P/TSX Composite or the S&P 500.
You or your fund manager will be competing against millions of sophisticated investors around the world who buy and sell securities every day. Collectively, they instantaneously process all available information and expectations about securities. Their trading decisions set market prices that reflect all that information. Of course, new information and events will cause prices to change, but these are inherently unknowable until they occur.
This is the essence of the efficient market theory developed by University of Chicago professor Eugene Fama in the 1960s. In the years since Fama, who won the Nobel Prize for economics in 2013, asserted his theory, other academic researchers have described circumstances where securities may be mispriced. Notably, behavioural economists attribute mispricing to various psychological errors and cognitive biases, such as overconfidence and loss aversion.
However, while securities may be mispriced at times, the challenge is to consistently recognize when this is the case. The evidence is that even the most sophisticated investors with the best resources are unable to do this regularly.
Indeed, actively managed investment funds consistently underperform low-cost passive index funds by a wide margin. For example, Standard & Poors reports that 89% of U.S. domestic equity funds lagged their benchmark over 10 years to the end of 2019.
Regardless of what you might read or see in the media, the reality is that no one can predict what’s going to happen in the future and what impact it will have on the markets. By embracing market pricing, you get off the treadmill of trying to forecast the future with all the emotional turmoil and potential for bad decisions that come with it.
Instead, you accept that volatility like we experienced in February and March is a normal if unpleasant part of investing. You prepare for it by holding a portfolio of passive investments that is broadly diversified within and across asset classes and geographies.
Truly smart investing isn’t about outthinking the markets. It’s about patiently sticking to an investment plan that allows you to capture market returns over the long term.