Have you ever had a situation where your expectations were not met? Perhaps your expectations were unrealistic? This scenario usually results in disappointment, stress, and frustration.
I believe that having realistic expectations is a prerequisite for success as an investor. I’ve made the mistake of not setting expectations with clients who were new to investing. In these situations, the client has certain expectations, even if those expectations didn’t come from me.
Invariably, these unrealistic or unmet expectations caused anxiety and frustration. If left ignored, unrealistic expectations can permanently damage an investor’s ability to build wealth in the greatest wealth-building tool known to mankind.
Examples of unrealistic expectations
How does this play out in investing? In my experience, unrealistic expectations show up in the following examples:
- Expectation: I should be able to avoid market drops.
Reality: it’s really difficult to time the market. It’s so hard to do that the alternative (being diversified and riding out bad markets) is a better option.
- Expectation: I should make money right away.
Reality: we don’t know how long it will take for you to realize meaningful returns. You might get lucky and see an increase right away. Other times, you’ll see negative returns soon after investing.
- Expectation: I can handle market volatility.
Reality: I don’t know anyone who doesn’t hate losing money. The reality is every market drop looks like the end of the world.
- Expectation: The market will listen to me.
Reality: the market does what it wants. Just because we think a stock should go up or down doesn’t mean it will. Often, consensus is wrong.
What should you expect from your investments?
Yearly returns are chaotic
Since 1926, the S&P 500 has returned 10.3% per year. This means if you invested money in 1926, you would have gotten a 10.3% compounded rate of return over the next 94 years.
This can cause people to expect a 10.3% return every year. In reality, the yearly returns are chaotic. It can be positive 30%, negative 30%, and everywhere in between. All these seemingly random returns averaged out to 10.3%, but rarely will you get 10.3%.
In fact, only twice has the S&P 500 returned between 9% and 11% (10.1% in 1993 and 10.9% in 2004). So, for all this talk about the market’s “average” return, your yearly returns are usually far from this standard.
Time in the market is better than timing the market
Because the yearly returns are chaotic, you should think of investing in terms of decades, not years (and certainly not months). The time you spend invested in the market is more important than when you put your money to work.
As I mentioned earlier, an unrealistic expectation is that it’s easy to avoid market drops and to wait to invest money “at the bottom” (we call this “timing the market”). Two reasons why this doesn’t work: One, the market has historically progressed upwards despite bad news. Two, even if you managed to pull out your money before a drop, you don’t get an “all-clear signal” to reinvest.
To illustrate how time in the market is your friend, consider your probability of positive returns for the following investment time periods:
- 1 year: 77.3% probability of positive returns
- 5 years: 92.54% probability of positive returns
- 10 years: 97.31% probability of positive returns
As you can see, the longer you invest, the higher your probability to earn a positive return.
Drawdowns are normal and expected
Markets don’t just move upwards. Part of investing is experiencing negative returns.
Look at it this way—if you are 30 years old, you can expect a 20% drop to happen 10 or 11 more times in your life. A retiree should expect four or five of these drops. Having this expectation of volatility helps. It doesn’t make it easy, but it puts crazy market news in perspective.
Diversification works—it just doesn’t always feel like it
Diversification means investing in different types of opportunities. This means various types of stocks (large companies, small companies, different sectors), investing domestically and overseas, and even investing in other assets like commodities, bonds, or real estate.
The goal of diversification is twofold: to capture return wherever it occurs and to decrease volatility.
Someone who is accumulating wealth might not be too concerned with lowering volatility. For him, diversification allows him to participate in whatever asset class is doing well. For a retiree taking withdrawals from her investments, diversification provides a war chest of bonds and cash that allow her to continue withdrawals during market drops without having to worry about running out of money.
But diversification also means there is something in your portfolio that you don’t like. As Vanguard founder Jack Bogle said, “I spend about half of my time wondering why I have so much in stocks and about half wondering why I have so little.”
You will want to own more stocks when they are going up, and you will want to own less when they are going down. Diversification allows you to own a portfolio that will increase your probability of hitting your financial goals (and help you sleep better at night).
Invest with confidence
Once your expectations for the stock market are in line with reality, you can confidently put your hard-earned money to work. You no longer have to worry about missing out on a hot stock or feel like you’ve been cheated by a rigged system when you experience a 20% drop. There’s no silver bullet or secret system. You simply need to save money, invest, diversify, and let the power of the stock market work for you.
