None of us lives in the long term. We all, to our perpetual discomfort, live in the present, in what we call the zone of anxiety where we are always buffeted – financially and emotionally – by short-term uncertainty.
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In the heat map below, most of the red losses coincide with holding periods of under five years, but there are no nominal losses in any holding period of at least 12 years. The challenge we face though, is that it can take some tough emotional sledding to remain invested in order to get there.
Figure 3: MSCI World Index annualised returns
The benefits of long-term investing
To illustrate some of the inefficiencies that may blight our investment journey, consider a real-world example: an investment in the MSCI World Index of developed equity markets in 24 countries. This would be considered highly risky as an allocation for your entire wealth, but it will serve as a simple case study to illustrate our point.
The heat map (Figure 3) shows the average annual returns that investors would have received from this market for any combination of quarterly purchase date and sell date since 1970.2
The long diagonal line from top left to bottom right shows every possible quarterly purchase date over the period; the dates along the top represent each point at which the investor could have sold. Thus, the red clusters close to the long diagonal show the negative average returns that investors would have suffered if they had bought into falling markets and sold shortly after, e.g., during stagflation of the 1970s, the collapse of the internet-bubble in the 2000s, or the 2008 financial crisis.
“When we approach investment decisions with a myopic short-term perspective – despite our objectives being long term – our perceptions of greater risk will lead to inappropriately high caution.”
While the crises represented by the red clusters are interesting, more crucial is the observation that they are all concentrated along the long diagonal, which shows the annualised returns from buying the index and then selling just one quarter later. As we examine diagonals further up and to the right, we see the effect of longer holding periods. The proportion of red dots diminishes and the fluctuations between high and low annualised returns are substantially dampened. For holding periods longer than 12 years, there is no red, regardless of the purchase date. This indicates that, in a sufficiently diversified portfolio 3 over the long term, the expected returns are positive; that is, investors earn a risk premium.
As long as you can hold for the long run (i.e. in excess of 12 years), and are in a diversified portfolio, it also doesn’t matter too much when you buy. There are certainly better and worse times to get into the market, but over the very long term, good and bad events average each other out and the effect of the purchase price will be diminished. 4
As obvious as this may be, our need for short-term emotional comfort can cause us to be reluctant to invest, or be too active when we do finally find a compelling reason to enter the market. Frequently we are both too passive and overactive at the same time with different portions of our wealth. Of course, not every investor gives away returns through active decisions along the journey; in the same way, not every investor leaves wealth languishing on the sidelines. But most of us do both to some extent, and some of us do one or the other to an extreme degree depending on where, in the investment cycle, we find ourselves.
As we’ve seen, investments are much more risky and volatile when viewed in the short term than the long term. When we approach investment decisions with a myopic short-term perspective – despite our objectives being long term – our perceptions of greater risk will lead to inappropriately high caution.