At a glance
Expected stock volatility declined after the US election, with the prospect of divided government reducing the risk of radical policy shifts. But uncertainties remain, especially over the course of the COVID-19 pandemic, which could lead to renewed market swings. Meanwhile, with stocks near to record highs, many investors fear entering markets at the wrong time. We believe investors should stick to a plan for entering markets and stand ready to take advantage of future spikes in volatility to earn yield.
Navigating an uncertain environment
Expected volatility fell swiftly in the wake of the US presidential election. The VIX index of implied US stock volatility fell from a peak of 40 ahead of the 3 November election, pricing daily moves of around 2.5% in the S&P 500, to 24 by mid-November, its lowest level since February. The decline partly reflected reduced uncertainty over US public policy. We expect a divided government – with Democrat control of the White House and Republican control of the Senate – to diminish the potential for radical US policies.
But many investors remain concerned that the lull in volatility will be short-lived. Plenty of uncertainties remain, especially regarding the course of the COVID-19 pandemic. Infection rates and hospitalizations in many parts of the world climbed to record highs in November. Meanwhile, with equity markets close to record highs, more investors have been worried by the risk of poor market timing. That has increased the temptation to sit on the sidelines in cash.
But that approach can be extremely costly. With central banks keeping interest rates at low levels and overall looking likely to accept moderately higher levels of inflation (e.g., above 2%), cash and the safest bonds are likely to deliver negative real returns for the foreseeable future. So to protect purchasing power, investors should keep cash holdings to a minimum and invest the rest for long-term growth.
There is no perfect time to enter the market, but even if there were, the approach yields little benefit. An investor putting USD 1 from their monthly paycheck into the S&P 500 since 1945 would have grown their portfolio to USD 253,645 if they put the cash to work straight away each month, or to USD 261,699 (a paltry 0.03% p.a. more) with perfect timing, only investing at levels the market never subsequently dropped below.
Since time in the market typically matters more than timing the market, we believe it is better to put money to work straight away. For a 60% stock, 40% bond portfolio, phasing in cash over 12 months would underperform an "all-at-once" approach by an average of 4.4%.
But this approach can feel too risky for some investors, so for these investors we recommend they take advantage of the volatile environment by:
So we recommend sticking to a financial plan that avoids excessive time out of the market, which can be a drag on long-term returns.
Key investment takeaways:
- Investors can be reluctant to put large sums to work straight away, especially during periods of uncertainty.
- We favor three approaches for those concerned about the risk of bad market timing, but who also want to manage opportunity cost: establish a schedule for averaging into risk assets; consider put-writing strategies to take advantage of dip-buying opportunities; and using structured investments.
- In the end, it is time in the market that matters more than timing the market.
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