The importance of being invested – A view from Mark Reidford’

Mark Reidford, founder of Innes Reid, provides his latest insight with the hope of delivering some reassurance that market volatility is a normal part of investing, the importance of being invested and why a switch to cash is not the answer.

Client meetings are currently dominated by the same subjects and I am sure you will all be able to guess the themes; inflation, energy prices, interest rates (or mortgage payments), collectively known as the “cost of living crisis”. Then throw in government indebtedness, the war in Ukraine and Chinese intentions towards Taiwan and you get a long list of client concerns.

We then move on to discuss markets as volatility is always a challenge for clients and in 2022, it has been nonstop. We believe that markets are undergoing some significant shifts as they struggle to price in inflation and come to terms with slower growth. However, we believe that once inflation peaks, the volatility should ease and positive growth should eventually return.

Market volatility is a normal part of investing. Typically, market falls of 5% happen on average three times a year, and markets have historically rebounded quickly. Declines of 10% to 20% happen every two and a half years, and severe declines of 20% to 40%, usually associated with recessions, occur every 8.6 years, and values have typically recovered within about 14 months on average. (Source Yardeni Research; Bloomberg. Data as of January 31, 2022)

For the markets at present, it is all about inflation

Since October 2020, a combination of factors has brought about some significant changes to the inflationary environment. These include:

• The rapid economic restart as pandemic-related restrictions eased, prompting severe disruption to supply chains.
• Post-pandemic pent-up demand pushing up global energy prices.
• Geopolitical tensions inflamed by the Russia/Ukraine conflict and related sanctions affecting the supply of energy and key commodities.

The combined effect of the above has led to widespread supply-side price inflation across energy, raw materials and manufacturing costs.

The importance of being invested

One of the most frequent questions I get asked when I have suggested that the economic outlook is not good and financial markets have clear risks at present is “why do we not sell and switch to cash?”.

We fully appreciate the current negative political and economic news understandably impacts risk appetite for Innes Reid clients. However, there are three key drivers to staying invested;

• Time in the market, not timing the market, delivers returns.
• Compounded long-term returns tend to outweigh the losses prompted by episodic crises.
• In the context of high inflation, cash is riskier than equities for capital preservation.

Firstly, trying to time the market to buy before ‘good’ days and sell before ‘bad’ ones is impossible. Staying invested is critical to capture all the good days that drive returns, but inevitably that means accepting some bad ones too. While it can be uncomfortable, it is better to stay invested.

This was recently brought home to me, having turned off the TV to save energy, I read a Bank of America research note that highlighted that an investment in the S&P 500, left alone from 1931 until today, would have produced a return of 19,020%.

However, by missing the 10 best days of each decade, the return would have only been 38%.

Secondly, we must remember compounding or growth on growth.

Albert Einstein famously said “compound interest is the 8^th wonder of the world”

If you invest £100 and it grows by 5% a year, after one year your investment would grow to £105. After another year, though, your balance would not grow to £110, but £110.25. The extra 25p is earned because the 5% growth is applied to the balance of £105, not £100 – the £5 growth earned in your first year has achieved 5% growth again in your second year.

Compounding becomes more powerful the longer you can harness its benefits for. Warren Buffet’s business partner Charlie Munger noted that “The first rule of compounding is to never interrupt it unnecessarily”.

Investing early and keeping the money invested can provide a massive benefit in later life:

Finally, when I say; in the context of high inflation, cash is riskier than equities for capital preservation, there is then a need to understand the difference between investment risk (volatility) and inflation risk (loss of purchasing power) over time. And while it is never comforting to see negative returns (as investors have done recently), it is important to put things in perspective.

Read our recent blog: Are you Benefiting from the Power of Compound Investing?

Investment risk vs inflation risk

It is important to consider ‘risk’ in a broad sense: not just investment risk, but inflation risk too, in the context of time.

During the last 20 years I have not worried too much about the impact of inflation on cash savings as we have been in a low interest rate low inflation environment but I have always made it clear only capital which needs to be immediately accessible, as a ‘liquid reserve’ or ‘rainy day’ fund, should be retained on deposit in a bank or building society deposit account.

Historically, deposit accounts have not produced sufficiently high, long-term returns to ensure that the real (inflation-adjusted) values of capital and income are maintained. Now with a high inflation environment the game is quite different and the pressure is really on and to stand any chance of protecting the real value of capital over the long term you need exposure to ‘asset-backed’ investments.

In light of the current inflationary pressures, I can’t ever remember being more sensitive to the potential long term impact on the real buying power of cash savings. Achieving the correct balance between cash and invested capital for each client has never been so important as cash is currently very expensive.

I have summarised this visually below:

Relationship between risk and time during a higher inflation regime

Source: Elston research, for illustration only

Investment risk, often measured in volatility, is the flip side of returns. By this I mean in a benign market environment, when things are going well, volatility is your friend – you are rewarded for the risk taken. But in a malign market environment, when things are getting difficult, volatility can very quickly become your enemy – you receive a negative return for the risk taken.

Cash may appear safe and not fluctuate but when inflation is high, cash is high-risk over the medium to long term as its buying power is destroyed by inflation.

Equities vs cash when inflation is high

By way of illustration, we can look at the relative performance of equities (for this example we will use S&P 500 in GBP) and cash during the period of high inflation in the UK from December 1972.

What we see is that staying invested and allocating to equities for the short, medium and long term in a high inflation environment can deliver preservation of purchasing power and capital growth.

As humans we are asymmetrically loss averse – a lost £1 gives more pain than a gained £1 gives pleasure – but in an inflationary environment it is important that investors are not risk averse and, in fact, risk should be embraced when taking a medium to long term view.

If you have any questions about the importance of being invested or you would like to review your Innes Reid portfolio, please do not hesitate to contact your adviser.

If you have not worked with us before, come and see us to learn more about how we do things. Book a complimentary meeting here or Call 01244 347 583 or email enquiries@innesreid.co.uk

This article is not personal advice. If you are unsure what is right for you, please seek personal financial advice.

Please note the value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.