With last month’s election and ongoing health and economic concerns related to COVID-19, uncertainty remains high, as it has for most of 2020. Unfortunately, this is likely to continue well into 2021 on health, financial and societal fronts. As investors, it’s never enjoyable to navigate periods like this, so we wanted to step back and reinforce our perspective on financial markets as we head into the close of 2020 (and if you are anything like me, it can’t come quickly enough). We’ll do this by reiterating three principles.
1. Financial uncertainty is the source of expected long-term gain.
Over time, it’s been well established that stock markets in virtually all countries have achieved higher long-term returns than safer investments. Without doubt, the primary reason this is true is because markets can go through stretches where they fall precipitously because of economic and political events or lengthy periods where stock markets underperform safer investments. Investors collectively understand this and price stock markets to provide expected returns above those of high-quality fixed income markets.
While it’s always tempting to believe that you can participate in these expected rewards without experiencing all the risk, the evidence is clear this is extremely difficult to do. As a result, as challenging as it can sometimes be, we believe the correct approach is to stick with your long-term plan 1) if you have been comfortable with it up to now, and 2) it is expected to achieve your long-term financial goals with high likelihood. This second part is key because the rigorous planning processes we employ incorporate the likelihood of poor market results occurring at one or more points during your lifetime.
2. Global markets have gone through periods of substantial uncertainty before and will in the future.
We have reliable records of the performance of the U.S. stock market going back to 1900. Here is a brief list of some of the most notable events that the U.S. market has navigated:
- Financial panic of 1907
- Establishment of the Federal Reserve central banking system
- World War I
- Spanish flu
- Great Depression
- Collapse of the gold standard
- World War II
- Cold War
- Korean War
- Vietnam War
- Inflationary pressures of the 70s and 80s
- Tech bubble of the late 90s
- Contested Bush-Gore election of 2000
- Great Financial Crisis of 2007–2009
This is not, of course, to say that the U.S. market can’t go through an extended period of poor performance, as this has actually happened on three different occasions (late 1920s through early 1940s, late 1960s through early 1980s, and the late 1990s through early 2010s), but it does show the long-term resilience of financial markets, illustrating the point that markets have generally done a good job of pricing the risk it exposes investors to.
3. Diversification remains as important as ever.
While one can never ensure taking more risk will lead to higher returns, we can reduce uncompensated risks through diversification. For most of the investors we work with, one of the most important steps to take is diversifying stock market risk across individual companies, countries and industries. I’ll focus here on diversification across countries.
We have been through a period of dominant performance of the U.S. market relative to all other countries. This has tempted some investors to question whether it might make more sense to increase their allocation to the U.S. market relative to other countries. Yet, in the stretch we’re currently going through, it’s clear there are a multitude of scenarios related to the election and coronavirus that could conceivably impact U.S. markets more negatively than other markets. The way to reduce this risk is diversification across countries. This same way of thinking can be applied to any number of other investing examples and — without the benefit of hindsight — the correct answer is most always diversification.
Remember, your financial plan is designed to help you weather turbulence, and these aren’t the first events to spur investor uncertainty, nor will they be the last. As your partner, we’ll continue to see you through stretches of uncertainty, making sure that your investment and financial planning strategies help position you to achieve your long-term goals.