Four rules you must follow to ensure you prosper 5 years from now

I wrote a blog in May warning investors to prepare for lots of bad news, uncertainty and market volatility. My thesis was that rising inflation, supply chain issues and rising rates would cause economic pain. Unfortunately, my prediction was correct, and we should expect the volatility to continue for many more months to come. 

It is possible that all you may see are risks and problems at the moment. But in 5 years from now, it is likely you’ll look back and see lots of (missed) opportunities because the rear vision mirror is always clearer than the windscreen. 

I’d like to share four rules which can help guide you to make great investment decisions over the course of the next year, and the rest of your life. 

Missing the best days of the market is a good lesson and a perfect metaphor

There are lots of charts that demonstrate that if you miss the 10 best days in the share market over a long period of time (say 10 years), it will have a dramatic negative impact on your overall investment returns i.e., you will earn half the returns or less. This chart is a good example. 

The lesson is that no one can pick the best days and the worst days. Therefore, if you sell your investments because you are concerned about volatility, you will inevitably miss the best days (best returns) and your overall performance will suffer. 

Another way to look at it is, that the best returns come in the years following a stock market decline. The chart below, which covers almost one century of data, illustrates this very eloquently (produced by Dimensional).  

 CHART

This concept applies to all markets and asset classes including residential property. 

Understand that volatility is normal

The event or issue that causes volatility (i.e., market uncertainty) is always unique and unpredictable. An event must be unpredictable to cause the market to fall dramatically because predictable events/issues are already systematically reflected in share prices. 

Volatility is normal and it should be expected. Volatility is a very important part of price discovery which ensures the market adequately reflects risks and opportunities. Volatility also aids investment strategies through long horizon mean reversion and/or dollar cost averaging. It is something that should be embraced, not feared. 

No one can tell you what will happen in the short term 

No one in the world has ever developed a reliable methodology to predict short-term asset class returns. The truth is that no one knows what will happen over the next few months. This chart demonstrates how random returns are. Therefore, that must be your starting assumption when making any investment decisions i.e., you don’t know what will happen in the short term. 

If you agree that we cannot predict what will happen in the short-term, then your only option is to ignore the short term and focus on the long run. 

Four rules to help you through volatile times 

A rules-based approach towards investing is easy to adopt because it guides clear decision making and avoids your decisions being unhelpfully influenced by emotions. And if the investment rules that you follow are routed in evidence-based methodologies, it further helps reduce your risks, as I’ve discussed