No, I’m not saying that the process of investing in index funds is difficult. In fact, it’s actually quite simple to build a diversified index portfolio, whether your money is invested at Vanguard, Fidelity, Schwab, or Etrade.
What makes investing in the stock market so difficult is tolerating its high volatility. Many investors are unable to stick with the stock market in the long run because of the ups and downs.
But those who stay invested in spite of the risks are rewarded with outsized returns.
Is it no surprise that Gallup has consistently found that only a minority of investors believe that the stock market is the best long-term investment? The volatility of the stock market is well-known and scares many investors away into what is perceived as less volatile asset classes such as real estate or bonds.
The money you make in the stock market is done by being able to tolerate its ups and downs. Your ability to stay the course, while it seems easy to do, is actually a quality that will set you apart from the vast majority of your fellow investors. And your ability to stay in the market when some or most of your fellow investors are letting their cash take a rest stop is how you will beat their returns in the long run.
The historical volatility of the stock market
The stock market undergoes lots of ups and downs. The standard deviation of the S&P 500 annual return is approximately 20%. From 1928-2017, the S&P 500 has fallen in a calendar year over a quarter of the time.
While the long-term trend of the stock market is up, there are a lot of down days in the stock market. In fact, from 1996-2016, a whopping 47% of trading days were down days. That’s a lot of days to be losing money and potentially being pessimistic about the stock market.
A common metric of a pullback in the stock market is the correction, defined as a decline of 10% from the previous high. A 10% market correction occurs, on average, once per year.
Even worse than a correction is a bear market, which is defined as a decline of 20% from the previous high. This, of course, occurs less frequently than 10% corrections, but still occur once every 3.5 years on average. And bear markets typically last 15 months on average.
It’s hard to stay in the market even during a bull market
Newer investors may not fully appreciate how hard the stock market can be, but even the current market has shown how it’s not easy to stay in the stock market year in and year out.
The current bull market has been going strong for over nine years, but there have been naysayers and bears about the market every year.
First, it was the concern that there was going to be a double-dip recession.
Then, there was concern that there would be a European sovereign debt crisis as various weak Eurozone nations were under fiscal pressure.
Then people though Donald Trump would blow up the economy (or the world) when he was elected President.
While most people agree that the Trump tax cuts are pro-business (at least in the short-run), his trade policy is decidedly anti-business and many are concerned that it would send the economy into a recession.
None of these concerns have so far materialized, and as of September 2018, the stock market is still near all-time highs.
There’s rarely a time when there is not a good reason to be pessimistic about the stock market.
But those that have chosen not to listen to the doomsayers and stayed in the market have been rewarded with continued positive returns.
Of course, there eventually will be a bear market, and it’s not just going to be because of “profit-taking.” Even when there is not a rationale for why a market is going down, the financial media will create a reason. This means that when the bear market happens, there will be a reasonable argument why the stock market could fall further. This will cause some investors to sell their stocks and head for the sidelines. They’re unlikely to get back in before the market turns around and rises above where they sold out.
If it were so easy, then everyone would do it
In a sense, the reason why making only the “average” return in the stock market ends up being above average is because few people are actually in the stock market 100% of the time to get the “average” return.
And it is understandable to see why. No matter how well the stock market has performed, there is usually a reasonable bear case to be made.
For this reason, I recommend that most investors hold at least a little bit of bonds in their portfolio to help cushion your portfolio during down markets. While your expected return will go down with the addition of bonds, it will increase your ability to withstand the bear markets and stay the course.
Some people belittle index investors for their “unsophisticated” investment strategies. But the ability to stay invested in the stock market, in spite of the volatility and the constant negative headlines, is how index investors routinely beat their counterparts who jump in and out of the market.
“Wall Street Physician,” a former Wall Street derivatives trader , is a physician who blogs at his self-titled site, the Wall Street Physician.
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