How Long-Term Investors Should React to Market Sell-Offs

After a historic six-month rally, the stock market has fallen 8% from its all-time high from the beginning of September, as of market close 9/21/2020. Although not as severe as the bear market crash earlier this year, it’s understandable that some investors may be concerned about a possible market correction.

However, it’s important to remember that markets are subject to periods of uncertainty. In the long run, despite endless causes for concern, investors are usually rewarded for being patient.

Every Market Recovery Is Unique

The recovery leading up to the recent market pullback was the fastest in history. Although the S&P 500 fell 34% from mid-February to late March, it first recovered its year-to-date losses in June and then all of its losses in August. The speed of this recovery, which occurred for many reasons including the reopening of the U.S. economy, was a surprise for many investors. Historically, recovering from a bear market decline requires 2 years or more.

This episode serves to highlight that stock market recoveries can happen unexpectedly – even as investors are still focused on the past. Perhaps the best example was the market bottom in March 2009. Few investors believed that stocks would ever recover. At best, many believed that there might be a “double-dip recession.” At worst, it would take a decade to rebuild the global financial system.

Staying Invested Through Highs and Lows Has Paid Off Historically

With the benefit of hindsight, those with the discipline to stay invested not only benefited from the early stages of the recovery but from steady returns over the next decade despite a variety of crises.

Chart: Rolling returns for the S&P 500 over 1, 5 and 10-year windows. Investors who can increase their time horizons can often increase their odds of success.

Sources: Clearnomics, Standard & Poor’s

Look Past Short-term Uncertainty, Stay Focused on Long-term Wins

This is not to say that the stock market always recovers quickly after every pullback. Instead, the point is that investors with a long time horizon can afford to look past short-term uncertainty. Investors who focus only on one-year rolling periods will find that the stock market is often negative. Extending that horizon out to five years improves the odds immensely.

Over ten-year horizons, there are only a handful of times since the Great Depression when the stock market was underwater. Over twenty-year horizons, there are exactly two periods: the Great Depression and the Global Financial Crisis. Holding a properly diversified portfolio of stocks and bonds improves the odds further.

Thus, investors ought to remain focused on the long-term recovery and properly balance their portfolios, rather than overreact to short-term market moves.