Learn to hold your nerve

Learn to hold your nerve

As a Chicagoan, the two sports I’ve grown up watching, among the many options available, are ice hockey and baseball.

In ice hockey we’ve got the Chicago Blackhawks, who have won the Stanley Cup three times since 2010 – with each victory celebrated with a grand parade, full of players, coaches and near-delirious fans. We’ve also got the Chicago Cubs in baseball, who hit their home runs at the beautiful Wrigley field. The Cubs hadn’t won the World Series for 108 years until last autumn, when the city went wild to celebrate the –historic–some (my father) would say – life-changing win.

One of the biggest lessons I’ve learned as a Chicago hockey and baseball fan is that the worst time to buy fan merchandise is right after these momentous victories. Economists shouldn’t be shocked that the price of replica jerseys, t-shirts and caps skyrockets when demand from supporters to show their devotion to their team is so high ... but a $200 hoodie just seems exorbitant. Markets are the same.

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At those times when demand is high, prices are high, and that is often exactly the worst time to buy. Equally, when markets are down, or when a baseball team hasn’t won the World Series in 108 years, prices are cheap.

This concept – that it is natural for markets and share prices to move up and down – is explored in the fourth instalment of our six-part Guide to the Markets Investing Principles. We find that the key to long-term successful investing is to keep calm as the markets move and be prepared to ride out short-term bouts of volatility.

As with most sports teams, every year has its rough patches. The red dots on this week’s chart represent the maximum intra-year equity decline in every calendar year, or the difference between the highest and lowest point reached by the market in those 12 months. It is hard to predict these pullbacks, but double-digit declines in markets are a fact of life in most years; investors should expect them.

But each year also has an annual return, the return from 1 January to 31 December, shown here in grey. Since 1986, despite average intra-year drops of 15.8 per cent, annual returns have been positive 22 out of 31 years.

Volatility in financial markets is normal and investors should be prepared upfront for the ups and downs of investing, rather than reacting emotionally and selling when the going gets tough (and when markets are cheap).

There is mathematically going to be a drawdown in every single year: as there will be a high and low point over 12 months. Despite these intra-year pullbacks, the equity market has recovered to deliver positive annual returns more than 70 per cent of the time.

In fact, this does not apply just to the UK equity market. The same can be said about the European and US stock market. Since 1980, despite average intra-year drops of 15.6 per cent, the MSCI Europe index has produced a positive annual return in 29 of 37 years. In the US, despite average intra-year drops of 14.2 per cent, annual returns have been positive in 28 of 37 years.