How to maximise long term investment returns by overcoming cognitive bias

*This content is brought to you by OMBA Advisory & Investments

Most investors, myself included, battle with the desire to “time” the market. Whether making a decision to deploy capital (invest fresh cash into the market) or remain invested (especially in times of volatility and uncertainty), there is a strong (some might say relatively rational) desire to buy in at the bottom and/or sell at the top (or before the bottom, in a market drawdown scenario). This desire, while seemingly rational, may prevent deployment of capital or cause investors to sell their positions at inopportune moments. Both actions would likely have an adverse impact on the long-term return of an investment portfolio. This is a common example of the many cognitive biases and behaviours that affect successful investing.

“Time in the market, not timing the market”

Unfortunately, nobody knows when markets will hit the low and the best daily performance typically occurs near the trough, making timing the market and investing at the bottom very challenging (near impossible). In addition, missing the best days (days with the largest positive performance) can have a significant impact on the overall long-term performance of an investment portfolio. The chart below depicts the impact of missing only a few of the best days in each calendar year over the last 20 years to 31 August 2022 for an investment in the MSCI World Index (total returns in US dollars). This period was chosen because it uses the earliest date at which daily total return data is available. Missing the single best day each calendar year would almost halve your investment return (annualised average). Missing the single best day each calendar year over the period would cost you over 260% (cumulative) in foregone gains. Missing the best 10 days each calendar year would leave you with just more than 5% of your initial investment (cumulative) – nearly a complete loss. Of course, this is an extreme and unlikely scenario as you would not practically only miss the best 10 days and hold investments for the other days, but the point is clear, remaining invested is important.   

“It pays to be deployed”

Investors are always nervous and generally with good reason, as markets do not move up in a linear straight line but rather in market cycles made up of rallies and drawdowns, highs, and lows. Long-term data, however, suggests that investments in global equities have taken on average 7.3 years to double and that equities mostly go up and rise by a greater magnitude than when they fall.[1] The below chart shows the long-term historic performance of global equities. Markets have gone up 74% of calendar years since 1970. For positive calendar years, global equities rose 19.6% on average. Negative years saw a 13% fall on average.

“Excess liquidity”: Capital at risk over a market cycle

The above two scenarios (and positive investment outcomes thereof) are dependent on an investor’s ability to remain invested during times of market volatility and uncertainty. The key to being able to remain invested is knowing your “excess liquidity” (i.e. capital at risk that won’t be needed over the next 3 to 5 years). This is critical to your asset allocation and investment strategy.  

We all want our wealth to grow, especially at a rate greater than inflation, but unfortunately, return entails taking risk and investing more than one can afford might mean needing to crystalise a loss (selling at the lows) to raise capital for liquidity needs. Hence, it is important to know how much risk (and what kind of risk) is appropriate for an individual.

Prudent allocating partly means that:

  • one understands how much capital they are able to responsibly invest in the context of their personal balance sheet;
  • deploying capital in risk-appropriate securities based one’s risk profile, investment goals and time horizons; and
  • ensuring that one has great diversification of the portfolio by country, sector and number of securities, hence Omba’s preference for using ETFs which inherently are extremely diversified.

A general rule of thumb that can be used is that any capital not needed over the next 3 to 5 years (to cover living costs or other large imminent expenses or purchases) can be fully deployed into risky assets. Let’s call this “excess liquidity”. “Excess liquidity” is referred to as such because it won’t be needed for liquidity needs over a medium time horizon i.e. it can remain invested in times of market stress and is not relied upon.

The table below, which looks at the MSCI World Index ($ TR) drawdowns in excess of 15% since 1970, demonstrates that the average High-to-Low-to-Recover duration is just over 3 years. To be more prudent one can add 2 years for a greater margin of safety. The data suggests that a 5-year outlook is generally adequate to ensure that your capital will fully recover (from intra-cycle drawdowns) or be worth more due to markets trending higher.

While there is hardly ever a perfect time to invest, historical data shows that time in the market (i.e. being deployed/invested) should result in better returns over the long-run.

As a result, investors looking to deploy new capital should try not to endlessly wait for “the bottom”. Waiting for the perfect timing may prevent deployment capital or cause an investor to miss the best days in the market and thus is it better to rather be cognisant of your liquidity needs and try to deploy excess capital/savings in a structured predetermined manner (eg. 50% upfront and the balance quarterly, or an equal monthly or quarterly deployment). Without a structured plan, it might never seem like the right day or time to invest. If you would like to add some attainable “timing of the market” some flexibility should be allowed to bring deployment forward in a market drawdown/selloff (i.e buy the dip).

For investors already fully deployed in the market, it is best to never panic sell. Rather stick to your investment plan and hold your course (especially in times of volatility, uncertainty, and drawdown). It is also important to have adequately considered your liquidity needs and risk profile to allow you to stick to your investment plan and avoid having to sell in a market drawdown.

At Omba we work with investors to help them understand these market dynamics, develop the right plan and then navigate the challenging times. Our process ensures that we invest in diverse portfolios of ETFs and shift portfolios between asset classes, countries and sectors depending on the market environment.

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[1] The 7.3 figure is based on the average annualized return of 9.47%. Alternatively, the “Rule of 72” is a simple estimate of the number of years needed to double an investment. It is calculated by dividing72 by the annualised rate of return e.g. 72/9.47 = 7.6 [years].

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