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The Critical Reason to Stay Invested

How a short period of time plays a big role in returns.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Ian Tam: Over the last week or so, equity markets continue to be very turbulent and very volatile. In fact, sliding further in terms of losses in the last few days. Very recently, I put out a video on three things to remember during turbulent times. Number one, keeping your emotions in check; number two, understanding your risk tolerance and sticking very close to the amount of risk you're able to take on; and number three, not trying to time the market.

So, today, what we're going to focus in on is a concept called critical months. And many investors know that equity markets are certainly very volatile. But you may not know that the performance of an index is often dependent on a very short period of performance history.

So, let's have a look at the chart on the screen here, which is an illustration of an equity index. And what I'm going to do is use an example of the 2000 tech bubble focusing on the year 2000 or so. And what this chart basically shows is that had you missed the one best month of performance within that given year, your performance in that year would have been about negative 18%. But had you been invested during the entire year despite it being a negative year in equities, your return would have been closer to negative 11% or negative 12%. So, still not a great scenario, but certainly would have paid you had you been invested during the entire year.

To go a bit further on this point, let's have a look at another chart, which is an illustration of a study that my colleagues Dr. Paul Kaplan and Dr. Maciej Kowara did in 2018. And they basically studied about 3,700 funds globally, equity funds specifically, over a 15-year period. And through the study, they defined what's called the critical months. So, a critical month basically is one that had you removed the performance of that month, the fund would have failed to beat its own equity benchmark.

So, amongst the 3,700 funds that they studied around the world over that 15-year period, they found that on average, there were just 7.4 or 7.5 critical months. So, the dependence on outperformance during those months is very small compared to the amount of history that we're actually looking over. And that's not just a global phenomenon, it also applies specifically to Canada. So, in Canada, my colleagues found about 304 equity funds that outperformed their benchmark over that same period. And they found that during that 15-year period, there were only 7.8 critical months.

So, again, this is just a reminder to all the investors out there that it's very important to make sure that you stay invested, despite the fact that there's a lot of volatility, because the performance of your fund over the long term depends on a very small period of time.

For Morningstar, I'm Ian Tam.