Why now is not the time to sell out of funds

While stocks are still forecast to fall further, bear markets have historically been great times to invest, explains Sam Benstead. 

British retail investors are rushing for the exits as stock and bond markets fall this year.

September outflows of £7.6 billion marked the eighth month of net retail withdrawals this year, the second highest ever from retail funds after March 2020 when £9.7 billion was pulled, according to figures from funds trade body the Investment Association (IA).

The pros are doing the same, with cash balances at 20-year highs among professional investors, according to Bank of America.

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Global shares have fallen 17% this year, or 4% when accounting for the weak pound, while UK shares have fallen 5% this year in response to rising inflation, slowing growth and higher interest rates. This has spooked investors, who moved to raise cash amid economic and market uncertainty.

But fund flow data from the IA shows that investors are doing the wrong thing – at least for their long-run investment returns

When share prices fall, expected future returns rise because the starting price is lower: paying low prices is better than a high price, assuming the stock market goes up in the long run, which it generally does if you’re prepared to wait.

This is why “pound cost averaging” is such an effective strategy. Through regular investing, investors buy more shares or fund units when prices are lower and fewer when they are higher, meaning that they lean into stock market falls and out during rising periods.

Alan Smith, chief executive of wealth manager Capital Asset Management, says that it is human psychology that causes us to be bad investors by selling when markets fall and buying when markets rise.

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“Since we first roamed the Savanah, we are hot wired to look for danger. Humans don’t like discomfort, and the focus from the media on negative news fuels this fear. This makes us bad investors as there is a general sense that things will go from bad to worse, making selling shares and funds and sitting in cash a more appealing option when markets are falling,” said Smith.

He says this leads to underwhelming returns for DIY investors. Citing a study by US financial researcher Dalbar, he said the S&P 500 has returned about 10% a year for 30 years but the typical investor has made about 7% as they rush into rising markets and panic during falling markets.

“Volatility is a feature and not a bug of investing, so investors need to prepare themselves mentally for market falls,” Smith said.

Smith says to avoid panicking when markets drop, investors need to write themselves a “policy statement” that they can turn to when they want to sell shares or buy more shares than normal. He suggests it includes rules like only looking at a portfolio twice a year and to follow a “data-driven” investment approach.

“The best portfolio is one that you can stick with through thick and thin. If that means reducing risk then that is what you have to do. This is simple but not easy,” said Smith.

A bear market is great for DIY investors with long investment time horizons. Figures from ClearBridge Investments, a US investment firm, show that historically after a 20% decline in American shares, six months later they typically rose by 4.1%, and by 11.8% 12 months later.

“Patient investors have historically been rewarded for staying the course the following year,” its research argues. 

But there are signs that stocks may be volatile over the next couple of years. Jeffrey Schulze, investment strategist at ClearBridge Investments, says that while the stock market has factored in higher interest rates, it is yet to account for lower profits if there is a recession, which he says is 75% likely in America. This means that stocks could have further to fall.

Schulze says: “The second leg of the market decline will be lower corporate profits. Earnings forecasts have not come down that much, which means that we have not reached the bottom of the market yet. Results for the final three months of the year will be key for assessing the impact of a worsening economy on companies.”

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Schulze says that healthcare, consumer staples and energy stocks will be sectors that should hold up better than the market due to their predictable earnings, and in the case of energy, being a beneficiary of higher oil prices.

BlackRock’s Investment Institute also says the US faces a “looming recession”, with higher mortgage rates already slowing down the housing market. It argues that while inflation will begin to subside, it will stay above central bank targets. Because of this, it recommends investors are “underweight” developed market shares.

It said: “We see rising rates causing recession as inflation persists. The US Federal Reserve is responding to the politics of inflation, or the pressure to tame it, we think.

“We see the Federal Reserve pausing but only after the economic damage of rate rises is clear. All this outweighs any expected boost for stocks after the midterm elections, in our view.

“We also think any resulting fiscal stimulus would only work against monetary policy in this new regime. We eventually see the politics of rates overtaking the politics of inflation as political focus sharpens on the economy into the 2024 elections.”