At some point over the past year, the financial media's inflation coverage transitioned from, "Will this high inflation persist?" to, "Here's how to cope with inflation that's here to stay!" It seems some investors have resigned themselves to a new normal of high inflation following decades of below-average consumer price changes. However, financial market data tells a different story, one of potentially softening inflation.
Breakeven inflation (BEI) rates offer a window into the market's inflation expectations. Defined as the difference between yields on nominal and inflation-protected bonds of the same maturity, BEI represents the inflation rate at which investors would be indifferent between the two. If actual inflation were to exceed BEI rates, investors would be better off with the inflation-protected bond; if inflation were less than BEI, the reverse would be true. BEI is therefore commonly interpreted as the average annual inflation rate expected over a given time horizon.
Investors can always expect uncertainty. While volatile periods like the one we're experiencing now can be intense, investors who learn to embrace uncertainty may often triumph in the long run. Reacting to down markets is a good way to derail progress made toward reaching your financial goals.
Here are three lessons to keep in mind during periods of volatility that can help you stick to your well-built plan. And if you don't have a plan, there's a suggestion for that too.
1. A Recession is Not a Reason to Sell
Are we headed into a recession? A century of economic cycles teaches us that we may well be in one before economists make that call.
But one of the best predictors of the economy is the stock market itself. Markets tend to fall in advance of recessions and start climbing earlier than the economy does. As the chart below shows, returns have often been positive while in a recession.
We are living in a time of extreme uncertainty and the anxiety that comes along with it. Against the backdrop of war, humanitarian crisis, and economic hardship, it's natural to wonder what effect these world events will have on our long-term investment performance.
While these challenges certainly warrant our attention and deep concern, they don't have to be a reason to panic about markets when you're focused on long-term investing.
Imagine it's 25 years ago, 1997:
- J.K. Rowling just published the first Harry Potter book.
- General Motors is releasing the EV1, an electric car with a range of 60 miles.
- The internet is in its infancy, Y2K looms, and everyone is worried about the Russian financial crisis.
A stranger offers to tell you what's going to happen over the course of the next 25 years. Here's the big question: Would you invest in the stock market knowing the following events were going to happen? And could you stay invested?
- Asian contagion
- Russian default
- Tech collapse
- Stocks' "lost decade"
- Great Recession
- Global pandemic
- Second Russian default
With everything I just mentioned, what would you have done? Gotten into the market? Gotten out? Increased your equity holdings? Decreased them?
Well, let's look at what happened.
- Single stocks have a wide range of returns. Only about a fifth of stocks survive and outperform the market over 20-year periods.
- They delist at a high rate, even those that have been around for a long time and have outperformed the market for 20 years.
- The chance of any single stock outperforming the market in the future is not meaningfully different when conditioning on its past performance.
Many investors end up holding large concentrated positions in single stocks, whether as the result of employee compensation or a handsomely rewarded stock selection. Familiarity with these stocks or a successful track record while holding them may discourage investors from diversifying. Unfortunately, this can lead to one of the most well-known cautionary tales in finances: tragic declines in wealth from losses in single securities. Data on the behavior of individual stocks suggests it's hardly rare for firms to underperform - or even go under, regardless of past performance.
A Study of US-Domiciled Mutual Fund Performance and Exchange-Traded Fund Performance