Investors across the world held their breaths last month as, on 5 August, global markets fell sharply after analysts predicted the US would soon slip into recession.
Although indices in all major economies dipped, none dropped so severely as the Nikkei 225, Japan’s benchmark index.
The Nikkei fell by 12%, recording its heaviest one-day fall since the Black Monday crash in 1987. However, a mere 24 hours later, the index rose by more than 10%, reversing most of the previous day’s losses, and marking its biggest-ever one-day growth in points.
The decline and recovery of the Nikkei speaks to the volatility and fluctuations inherent in investing, but it also highlights the value of an evidence-based approach. This method not only provides greater security, helping you weather short-term dips, but it can also pave the way for long-term success.
Read on to discover how an evidence-based approach to investing can help protect you against volatility, such as the kind seen last August.
The market typically delivers over longer time horizons, so remaining resilient amid short-term dips can help you achieve steady growth
One of the key tenets of an evidence-based approach to investing is to focus on long-term goals and ignore short-term noise or trends as much as possible.
Had you been tempted to exit the market and liquidate your investments on 5 August, you would have missed the chance to recover most of your losses the next day and go on to make stronger returns by the end of the month.
Indeed, research by Schroders reveals that, historically, liquidating amid significant market declines would likely have been a bad decision.
For instance, investors who shifted to cash after the first 25% drop of the Great Depression in 1929 would have waited until 1963 to recover their losses, compared to 1945 if they had stayed invested in the stock market.
Likewise, if you switched to cash after the first 25% drop in markets in 2008 you would still not have fully recovered today. If you stayed in the market, you would have recovered in around 2013.
So, switching to cash has historically meant it will take you longer to recover from losses. This is largely because, over longer time horizons, the market has a stronger chance of outpacing inflation, boosting your ability to recover any previous losses by yielding steady, long-term gains.
Cash, on the other hand, is less effective at beating inflation, meaning the time it would take to recover based on interest returns is considerably longer than investments.
The graph below shows the percentage of time periods where large-cap US stocks and cash have beaten inflation between 1926 and 2023.
Source: Schroders
As you can see, over a one-month period, cash and stocks have a roughly similar chance of beating inflation – that is, returning real-term gains on your wealth.
However, as time goes on, the chance of stocks beating inflation increases, rising to 100% after 20 years.
Conversely, the chance of cash beating inflation decreases at first before increasing slightly to 65% after 20 years.
So, the data suggests that exiting the market and shifting to cash to limit your losses has historically not been the best strategy for recovery.
The evidence-based approach of remaining resilient and maintaining your holdings amid significant dips has typically resulted in a faster rebound.
This strategy is also supported by the swift recovery of global markets, namely the Nikkei, after 5 August.
Diversifying your portfolio can help shield you from volatility while also opening you up to broader returns
Portfolio diversification is another key component of an evidence-based approach to investing.
By diversifying your investments across various asset classes, sectors, and regions, you minimise your exposure to the volatility of any single market. This approach also allows you to tap into a broader range of markets, increasing your potential to capitalise on diverse opportunities.
For example, the table below highlights the annual performance of various global indices over the past decade.
Source: JP Morgan
As you can see, predicting how different markets will perform in any given year is almost impossible, and success in one year does not guarantee continued success in another.
For instance, the UK FTSE All-Share was the strongest performer in 2016 but the weakest in 2017.
Portfolio diversification sees you spreading your holdings across different sectors, assets, and (as in this case) regions, not only to reduce the impact of market downturns but also to position yourself for broader returns.
For example, had you held all your investments in the UK FTSE All-Share in 2020, you would have probably suffered considerable losses as the index posted -9.8% over the year. However, every other index on the chart posted gains in 2020, with the MSCI Asia hitting 25.4%.
So, had you spread your investments rather than confining them to one region, your losses would likely have been counterbalanced and you would have captured returns from broader markets.
Similarly, on 5 August, though most indices posted losses, had you confined your investments to the Nikkei 225, you would have lost considerably more than if you had a regionally diversified portfolio.
An evidence-based approach to investing, emphasises the importance of portfolio diversification for this reason. This strategy not only helps to weather market volatility but also increases the potential for long-term, sustainable returns.
Get in touch
A financial planner can help ensure your investments are diversified, limiting the effects of any future fluctuations. They can also work with you to develop long-term goals based on your values, helping you stay focused on what truly matters and avoid being swayed by short-term market trends or noise.
To speak to a financial planner, get in touch.
Email us at hello@vwmwealth.com or call us on 0141 229 4004.
Please note
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
