Recently we’ve been asked how we can be confident about investing when the world seems so uncertain. It’s because we’ve been through rough times before, which helps us understand that short term losses are not an indication of long term returns.
Below is a chart showing a composite of all of our clients’ returns starting in March of 2002 (Point A). Six months later (Point B), account values were an average of almost 13% lower. Jumping ahead to Point C we can see that despite the short term loss from A to B, returns averaged a 6.6% annualized return. This was good compared to the more conservative alternatives of cash which only earned 2% (three month Treasury bills), and bonds which only earned 5.8% (Barclays US Aggregate Bond Index).
Returns from Point B were better, averaging 8.8% to the end of 2010. Of course if we had a perfect crystal ball, we would have sold all stock holdings earlier in 2002 and bought back at the very bottom in late 2002 (and sold everything at the peak in 2007 and bought back at the bottom in 2009, and then sold everything in early 2010, and so forth…however no one knows everything, especially about the future).
There are a couple of important lessons from this example.
First, you should have enough funds in cash and bonds to cover withdrawals you’ll need to make in the next few years, so that you will not be forced to sell stock positions if prices are low. We use our risk capacity measurement to set appropriate allocations for cash and bonds based on expected withdrawals.
Second, returns from lower prices are higher, so use lower prices as opportunities to buy.