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The science behind keeping investments in lockdown during COVID-19

20 July 2020 Old Mutual Corporate Consultants

The speed of the market crash and the subsequent bounce-back — as global signs suggest that the COVID-19 pandemic may be under control — reveal once again that the real danger to long-term investment returns is not market volatility but rather investor behaviour.

This is according to Collin Nefdt of Old Mutual Corporate Consultants, who says “we all know that the markets swing between highs and lows. When the dip is as dramatic as in the COVID-19-induced market sell-off, it’s not always as easy to keep the faith; however, when long-term investors don’t hold their nerve and instead opt to pivot their portfolio to lower-risk assets during a crisis, they simply lose out in the long run”.

Many investors have been surprised at the sharp stock market recovery. “Granted, the COVID-19 pandemic is a unique event; but we need to remember that investor behaviour is not. Extreme market volatility is when the embedded emotions of fear and greed are amplified — heightened fear is virtually universal in how we react to a crisis.

“Recovery is, therefore, the nature of the markets, and perhaps the best way to see this is to reflect on the long-term trends of an actual fund,” he says. While difficult to truly understand at this stage, the nature of the COVID-19 market recovery can be linked to the rapid response of central banks.

Nefdt uses the track record of the first equity mutual fund in the US, launched in 1924, and that of the first balanced fund, launched five years later, to illustrate his point. These two funds are the Massachusetts Investors Trust (MIT) and Vanguard Wellington Fund, respectively.

Plotting their growth since 1930, which included the effects of the Great Depression and every other major market event since, Old Mutual found that the MIT has delivered a real compound annual growth rate (CAGR) of 6.1% compared to the balanced fund’s real CAGR of 5.2%.

“This long-term perspective is important, as it demonstrates that the funds have stood the test of time and show that long-term investment programs do not have to be derailed by a single market event.

Nefdt says this overwhelming evidence of the resilience of markets to produce positive returns over the long term is a powerful tool for investors. Added to that, he offers three key COVID-19-inspired lessons to reinforce the importance of trusting the markets.

1. Follow the science
The near 100-year track record of the two pioneer funds is the strongest evidence that long-term wealth creation is not a continual, straight, upward-sloping line.

A buy-and-hold investor of the actively-managed MIT fund, for instance, would have experienced three prolonged periods of little or no real growth. In between such phases, however, there are periods of rapid appreciation.

2. Flatten the (risk) curve
Investors in balanced funds can take comfort from the smoother return pattern over the long term. This shows that the diversified nature of the fund does as advertised by spreading exposure across different asset classes.

“The diversification embedded in balanced funds can smooth the long-term investment journey, but naturally, this will come at a return discount. If we overlay the annual returns of the diversified Vanguard Wellington Fund over the equity-based MIT fund, we see that the incidence and quantum of negative returns is lower.

“The argument is that the balanced fund return pattern, with its ability to dampen losses, can help to keep investors invested when times are tough.”

3. Keep your investments in lockdown
The final lesson is an age-old one: stay the course and we recommend consulting your financial consultant.

Nefdt says the two funds clearly demonstrate this in their respective long-term real returns of 6.1% for the equity fund and 5.2% for the Vanguard balanced fund.

He says the higher return from the MIT fund is not surprising as equity funds should outperform a balanced offering over time and result in massive terminal wealth differentials between the two funds. He cautions that this differential will only be ‘banked’ if the investor had stayed the course and not withdrawn from the market.

This is an important lesson to share with retirement fund members who will have experienced a sharp decline in their retirement account values over the last few months, concludes Nefdt.

He hopes that using the real-world results from these two funds helps to drive home the message that single market events are unable to prevent investment markets’ steady, inevitable rise.

 

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