401(k) Adviser: It's a good time to review some basic truths about investing

Recent market volatility has shaken investor confidence. If you're second-guessing your long-term investment strategy, now may be a good time to review some basic truths about investing.

The math of recovery

Most investors are averse to risk for good reason. When the market goes against you and your account experiences a significant decline, you need an even bigger gain in percentage terms to fully recover. For example, a 30% decline requires a 43% gain, and a 50% decline requires a 100% gain to get back to the previous high.

History shows the time it takes stocks to recover from a sharp sell-off can vary significantly. A full recovery can be as short as the one we experienced in 2020 when it took the market only 26 weeks to bounce back from a 35% decline in February.

Contrast that with the 25 years it took to get back to even after the market crashed 87% during the Depression. Looking back over the past 100 years, the average recovery time from a bear market has been 19 months.

For most 401(k) investors, however, periodic market declines are arguably not so problematic. That's because the vast majority are long-term investors who invest with every paycheck. By "dollar-cost averaging" (making the same monthly contribution which buys more shares when the market drops) 401(k) investors see their average cost per share lowered, which reduces account volatility.

Historically, the U.S. stock market has delivered plenty of "corrections" motivated by an array of impossible-to-predict events such as terrorist attacks, pandemics and financial crises. In fact, over the past 100 years, the U.S. stock market has declined on average three years out of every decade.

Through it all, a buy-and-hold approach to investing in U.S. stocks, as measured by the S&P 500 Index, has yielded an average annual rate of return of 10.1% over the past 20 years, 9.8% over the past 30 years and 10.5% over the past 50 years.

Diversification

While bonds are the most common asset recommended to diversify a stock portfolio, inflationary pressures present in 2022 have rendered bonds a much less effective diversifier than usual. Here are a few others:

Real estate has a solid long-term track record of being a good diversifier for a portfolio of stocks and bonds. If you're looking for something similar within your employer's 401(k) offering, understand that a Real Estate Investment Trust (REIT) mutual fund is not a good proxy for owning real estate. A better hedge against unexpected inflation in a 401(k) plan is a commodity-based index fund.

Treasury Inflation-Protected Securities (TIPS) mutual funds are also a good diversifier. TIPS are government bonds that have their par value adjusted upward every six months by the rate of inflation. Because the maturity value of the bond is indexed to inflation, the bond's semi-annual interest payments adjust upward as well.

Stable value funds are an even safer diversification play and are available only in an employer's qualified retirement plan. These funds operate like a money market fund on steroids. They invest in short-term fixed-income instruments with maturities of up to six years. Because these funds buy insurance protecting their portfolio against short-term losses from rising interest rates, they are allowed to report a steady net asset value. Stable value funds offer the conservative investor's trifecta: attractive yields, liquidity and no interest rate risk.

Using a diversified investment strategy also provides you the opportunity to execute a powerful performance-enhancing strategy called rebalancing. In a year when one category declines sharply, you simply sell some of the holdings in other categories to raise enough capital to buy more of what has declined.

Like dollar-cost averaging, rebalancing helps you resist the temptation to move away from investments causing you pain. It forces you to buy when prices are down and sell when prices are high. Over time, taking the emotion out of your investment decisionmaking can meaningfully reduce the volatility of your overall portfolio while boosting your expected long-term rate of return.

Michael J. Francis is president of Francis Investment Counsel LLC in Minneapolis and Brookfield, Wis. He can be reached at michael.francis@francisinvco.com.