Understanding cycles is vital to your long-term investment success. Most folk intuitively understand that the economy and the financial markets go through cycles. The economy expands and then it contracts, the stock market rises and falls, interest rates go up and they go down. Cycles just come with the territory in a free market economy, but when it comes to evaluating investment performance, too many investors behave as if cycles don’t exist. The mutual funds and investment managers who have earned the highest returns over a given period of time, whether it is three years or five years, gather the largest share of investors’ assets.
Three or five years may seem as though it is long enough to evaluate investment performance, but it is not. The proper way to evaluate investment performance is to measure over a full market cycle. Why? Because just as the economy and the broader stock market go through cycles, so too do investment strategies. More aggressive investment strategies are likely to outperform in up markets, but they are also likely to trail badly in down markets. The opposite is true of a more defensive strategy.
I bring this to your attention because starting this month and continuing through March of next year, we will be hitting the five-year anniversary of the bear market lows of 2008 and 2009. That means the five-year return numbers for mutual funds will soar. Five-year compound annual return numbers in the mid-20s will become commonplace in the promotional material of mutual funds. Don’t allow yourself to fall prey to these aggressive sales tactics.
Over a full market cycle, the prospect of achieving anything close to 20% compounded annual returns is remote. An emotionally charged decision to reallocate assets from your defensive strategies to your more aggressive strategies solely on the basis of past performance could cost you dearly. Your timing is likely to be far off the mark. Aggressive investment strategies may still have some room to run at the front of the pack, but they are much closer to the end of their up cycle than the beginning.
Retired investors and those soon to be retired should stay the course with a prudent approach.