The importance of long-term investing

This challenging market environment has created a situation which can lead to some biased decision making. Recognising this will prevent investors from making decisions that could negatively impact their long-term investment performance.

Since the start of 2022 global equities have fallen almost -10% but were down -25% at their lowest point in that period. UK government bonds have fallen -20%. This volatility and decline in asset prices, even in bonds, which are supposed to be safer, have caused consternation among investors.

At the same time higher interest rates and the fall in UK gilts mean that investors can net a respectable ~5% return in cash and short dated bonds.

Some investors have concluded that to get the best returns in the coming years, they ought to move from risk assets to cash. Not only does this impact long term financial planning, but it also falls into a number of psychological traps that investors, during a time consternation, can be prone to.

First, we examine the premise that because the last two years have been challenging for investors, now is the time to reduce risk. This approach is flawed as it looks at the performance of a diversified portfolio over the last two years and compares it to the performance of short-term bonds or cash can deliver over the next two years, concluding that increasing the allocation to cash and low risk bonds is the more attractive of the two options.

It assumes that the next two years will be the same as the last two years for risk assets. What it doesn’t consider is when asset prices are depressed, the expected future returns for these assets increase. This is known as recency bias.

The second reason why it is not necessarily rational to reduce risky assets and invest in low-risk bonds and cash is that it ignores the fundamental relationship between risk and reward. We know that over time taking risks leads to better rewards and while this does not play out over every timeframe it does play out over the long term.

The last two years have been challenging for risky assets, but we have not reached a point where the relationship between risk and reward is broken.

My final point relates to the importance of remaining invested. The expression “time in the market beats timing the market” is often repeated in the investment industry. This is proven when we look at the long-term return of equities, bonds, and cash, which show that maintaining risk leads to better returns over time. When we look at the rolling 10-year returns of equities there are very few periods where equities have delivered negative returns, and if they have, these were short-lived. This confirms that time in the market does beat timing the market, even when emotions may tell us otherwise.

Deciding that it is a good time to divest portfolios and hold cash is deciding that one knows that risk assets will underperform cash in the near term, and will then be able to recognise when this is no longer the case and it is safe to reinvest. It is impossible to know this with certainty, even for investment professionals with decades of experience, and can easily result in the wrong decision.

When discussing this subject of biases and blind spots, most people will readily agree that extrapolating future performance from past performance does not make sense, or that over time more risk will deliver better returns, and that in deciding to go to cash or to add back risk will lead to making the wrong decision. However, when their investments are involved, it becomes much harder to not be influenced by one's emotions. The best recourse in this situation is to fall back on the statistical data and act in a way that is most likely to deliver the best return on a balance of probability.

James Hunter-Jones, Senior Investment Manager