What You Should Know About Financial Markets
Let time work in your favor. Let the market worry about itself.
Financial markets are unpredictable. No matter how much research you do and how closely you follow the news, trying to “time the market” usually means withdrawing too early and investing too late.
Most investors see better performance by focusing on the long game. With a diversified portfolio and a patient and disciplined approach, the more time you give your investments in the market, the better your portfolio performs.
When you try to time the market, you also risk short-term capital gains taxes. Even if you make a profit with constant buying and selling, these taxes quickly eat into your gains. Hold your assets for over a year, and you’ll avoid these short-term taxes.
If you do need to make adjustments, try to keep them to a minimum. The best way to adjust your asset allocation is to look at how much time you have to reach your goal. The closer it gets, the less risk you’ll want to take.
Got more time? There’s more to unpack about financial markets.
In 5 minutes
In this guide, we’ll explain:
- Why a long-term strategy is often the best approach
- The problems with trying to time the market
- How to accurately evaluate portfolio performance
- How to make adjustments when you need to
Why a long-term strategy is often the best approach
Watch the market closely, and you’ll see it constantly fluctuate. The markets can be sky high one day, then come crashing down the next. Zoom in close enough on any ten-year period, and you’ll see countless short-term gains and losses that can be large in magnitude. Zoom out far enough, and you’ll see a gradual upward trend.
It’s easy to get sucked into market speculation. Those short-term wins feel good, and look highly appealing.
But you’re not trying to win the lottery here—you’re investing. You’re trying to reach financial goals. At Betterment, we believe the smartest way to do that is by diversifying your portfolio, making regular deposits, and holding your assets for longer. Accurately predicting where the market is going in the short-term is extremely difficult, but investing regularly over the long-term is an activity you can control that can lead to far more reliable performance over time. The power of compounding is real.
By regularly investing in a well-diversified portfolio, you’re probably not going to suddenly win big. But you’re unlikely to lose it all, either. And by the time you’re ready to start withdrawing funds, you’ll have a lot more to work with.
The basics of diversification
Diversification is all about reducing risk. Every financial asset, industry, and market is influenced by different factors that change its performance. Invest too heavily in one area, and your portfolio becomes more vulnerable to its specific risks.
Put all your money in an oil company, and a single oil spill, regulation, lawsuit, or change in demand could devastate your portfolio. There’s no failsafe.
The less you lean on any one asset, economic sector, or geographical region, the more stable your portfolio will likely be. Diversification sets your portfolio up for long-term success with steadier, more stable performance.
The problems with trying to time the market
There are two big reasons not to try and time the market:
- It’s extremely difficult to consistently beat a well-diversified portfolio
Many investors miss more in gains than they avoid in losses by trying to time a dip. Even the best active investors frequently make “the wrong call.” They withdraw too early or go all-in too late. There are too many factors outside of your control. Too much information you don’t have.
To beat a well-diversified portfolio, you have to buy and sell at the perfect time. Again. And again. And again. No matter how much market research you do, you’re simply very unlikely to win that battle in the long run. Especially when you consider short-term capital gains taxes.
Any time you sell an asset you’ve held for less than a year and make a profit, you have to pay short-term capital gains taxes. Just like that, you might have to shave up to 37% off of your profits. With a passive approach that focuses on the long game, you hold onto assets for much longer, so you’re far less likely to have short-term capital gains (and the taxes that come with them).
You don’t just have to consistently beat a well-diversified, buy and hold portfolio. In order to outperform it, you have to blow it out of the water.
And that’s why you may want to rethink the way you evaluate portfolio performance.
How to evaluate portfolio performance
Want to know how well your portfolio is doing? You need to use the right benchmarks and consider after-tax adjustments.
US investors often compare their portfolio performance to the S&P 500 or the Dow Jones Industrial Average. But that’s helpful if you’re only invested in the US stock market. If you’re holding a well-diversified portfolio holding stocks and bonds across geographical regions, the Vanguard LifeStrategy Funds or iShares Core Allocation ETFs may be a better comparison.
Just make sure you compare apples to apples. If you have a portfolio that’s 80% stocks, don’t compare it to a portfolio with 100% stocks.
The other key to evaluating your performance is tax adjustments. How much actually goes in your pocket? If you’re going to lose 30% or more of your profits to short-term capital gains taxes, that’s a large drain on your overall return that may impact how soon you can achieve your financial goals.
How to adjust your investments during highs and lows
At Betterment, we believe investors get better results when they don’t react to market changes. On a long enough timeline, market highs and lows won’t matter as much. But sometimes, you really do need to make adjustments.
The best way to change your portfolio? Start small. Huge, sweeping changes are much more likely to hurt your performance. If stock investments feel too risky, you can even start putting your deposits into US Short-Term Treasuries instead, which are extremely low risk, highly liquid, and mature in about six months. This is called a “dry powder” fund.
Make sure your adjustments fit your goal. If your goal is still years or decades away, your investments should probably be weighted more heavily toward diversified stocks. As you get closer to the end date, you can shift to bonds and other low-risk assets.
Since it’s extremely hard to time the market, we believe it’s best to ride out the market highs and lows. We also make it easy to adjust your portfolio to fit your level of risk tolerance. It’s like turning a dial up or down, shifting your investments more toward stocks or bonds. You’re in control. And if “don’t worry” doesn’t put you at ease, you can make sure your risk reflects your comfort level.