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Market peaks shouldn’t be scary

It’s hard to open a financial newspaper, check your social media feed or even listen to the news these days without hearing someone talking about how the markets have reached a new peak. You’d think that the markets reaching an all-time high would be considered good news. But nine times out of ten, most of those news stories tend to trumpet every market peak as a dire warning to investors about the inevitable (and likely precipitous) drop that’s surely just around the corner.

Don’t get me wrong – the markets certainly do decline on a regular basis. The average intra-year variability of the S&P 500 is about 17 per cent. Every five years or so, the markets experience a “correction,” which is defined as a decline of more than 20 per cent in value. So there’s no question that market drops will eventually follow market peaks. But is listening to the pundits’ latest predictions really the most reliable way to decide when to put your money in or out of the market?

It might surprise you to know that, since 1926, the average three-year compound return for the S&P 500 was 10.6 per cent. If the doomsayers were right, you’d expect significantly lower returns in the years after the index reached a new high. But in fact, the average three-year compound returns following those months where the S&P 500 posted a new record high were virtually identical, at around 10.5 per cent.

That tiny difference is a perfect illustration of what Warren Buffett means when he says that “the cost of being out of the market far exceeds the cost of being in the market.” It also explains why trying to time the markets simply doesn’t work as a long-term strategy, and why using market peaks as a signal to abandon stocks entirely is much more likely to cost you in the long run than it is to save you any of your hard-earned dollars.

Of course, just because the numbers tell us that staying invested in stocks is the most reliable way to ensure long-term growth, doesn’t mean it’s always easy. Depending on the depth and length of any given decline, market corrections can run the gamut from slightly uncomfortable to outright terrifying.

Over the last 22 years or so, we’ve had three market corrections that can only be classified as “real doozies.” In the year 2000, the tech wreck saw the markets drop by almost 50%. In 2008 and 2009, the financial crisis shaved 52 per cent off the peak levels that were reached in 2007. Most recently, in 2020, we endured a 38 per cent market correction thanks to the coronavirus epidemic.

If you were unlucky enough to buy stocks at the market peak in 2000, you would’ve seen your investment cut almost in half overnight as the S&P 500 dropped from 1500 to 800. But the news isn’t all bad. Today that same index stands at about 4700 – meaning that, if you’d had the courage to just sit tight and wait, your original investment would be worth more than three times as much today as it was at that “all-time high” in 2000.

To make matters worse, jumping out of the markets at each new peak isn’t just unlikely to add anything to your returns. Over time, it will almost certainly cost you a significant portion of your portfolio.

On average, stock markets advance about 75 per cent of the time and retreat only 25 per cent of the time. So if you sell your stocks every time the markets hit a new record, most of the time, you’ll find yourself sitting on the sidelines while the markets continue to climb even higher – leaving you in the unenviable position of either staying out of the stock market forever, or eventually having to buy back all those securities you sold at a substantially higher price.

Given that stock market declines are both an unavoidable reality and yet can almost never be accurately timed, what’s the average investor to do? The advice I give my clients is to forget about the things you can’t control, and focus on the things you can.

First, have a plan and investment policy in place that will help you stay on track regardless of which way the markets are headed. Second, if you’re drawing income from your portfolio (or plan to do so anytime soon), put at least three years of income aside in something that won’t be impacted by a stock market decline, so you won’t have to cash out any stocks at fire-sale prices should a correction occur.

Given how low the current yields are on things like GICs and government bonds, it can be tough to put that much money into one of these guaranteed assets. But it’s important to resist the temptation to search for a higher yield that will reduce the safety of your safe haven assets. High-yield bonds and preferred shares may look more enticing than a boring old GIC. But they also tend to tumble at the same time the markets drop, which pretty much defeats the purpose of buying them in the first place.

Lastly, I remind my clients not to forget the biggest advantage they have on their side: time. The last two years have been a rollercoaster for the markets. But the world’s economy is already bigger today than it was before the COVID-19 pandemic hit.

Only time will tell whether the current highs are a prelude to a correction, or just another way station in the bull market that’s been underway ever since the last financial crisis ended. Fortunately, you don’t need to avoid every market decline to be a successful investor.

For the vast majority of us, time, a steady hand and a little discipline will do all the hard work for us. Provided we don’t panic, or let ourselves get in our own way.

This article is supplied by Alan MacDonald, an investment advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.