How market crashes and inflation can combine to derail your investments

Equity markets can suffer large and long—lasting drawdowns when inflation is taken into consideration. Here we illustrate how global stock markets have performed since the 1970s and outline how clients may want to approach long—term investing.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
Market data

Investing in global stock markets over the long run is a proven way to share in the growth of human creativity, innovation and productivity. Yet while long—term equity returns are attractive, short and medium—term returns are not guaranteed, and your portfolio can be subject to substantial turbulence over time.

As you’ll be aware, the past decade has been very kind to investors. A combination of low starting valuations, benign inflation and solid economic growth, following the depths of the financial crisis, has seen investor wealth surge.

At times like this it becomes all too easy to get sucked into the narrative of the day: that stocks will march ever upwards, that valuations will not come down and that the political climate will stay friendly to wealth creation. While there is no reason to believe that the inflationary bust of the 1970s, tech crash of 2000 and the more recent global financial crisis will be repeated in anything like the same magnitude, at some point this current upcycle will end and equity investors will need nerves of steel to avoid capitulating in future sell—offs.

While it was barely investible in its early days, the MSCI World Total Return Index has data going back to 1971. A theoretical £100 pounds invested in March of that year, with dividends reinvested and no frictional costs or fees, could have been worth £10,472 by July 2018. The long—term chart below appears to be an almost soothing inevitable uptrend, with those early market crashes such as ‘Black Monday’ in October 1987 just a hiccup in time.

MSCI World Total Return Index 31.03.71 to 31.07.18

Source: Bloomberg, IG Group, August 2018

What is not obvious is the drawdowns that investors would have faced over the 47—year time period. A drawdown measures the peak to trough loss from an index high. In the chart above you can see that June 2000 was a peak, with a low coming in January 2003.

The oil shock that triggered a global recession in 1974 is prominent, while 1987, 2003 and 2009 are other painful reminders that investing can be very risky.

MSCI World Total Return drawdown (GBP)

Source: Bloomberg, IG Group, August 2018

Inflation—adjusted returns are what matter

Both these charts ignore the pernicious impact of inflation. Include inflation and it looks rather different. Your £100 would have grown to £729, a compound annual return of 4.3% before fees. But start instead in March 1981 and the story would have been rather better; £100 invested then would be worth £1200 in real terms and your investment would have grown at 6.8% per annum (doubling in real terms every ten years), a very attractive return profile.

MSCI World Total Return inflation—adjusted (GBP)

Source: Bloomberg, IG Group, August 2018

The inflation—adjusted chart makes it clear that investors in equities can have long—term periods where their investments fall in value. We’ve written before about pound cost averaging, which results in a smoother return profile, but it can still be tempting to give up hope after prolonged poor returns. Nevertheless, systematically investing over time should bring some of the emotion out of making investments, giving a greater chance of recovering values.

The MSCI World has the benefit of being a globally diversified index, smoothing out some of the worst volatility of individual countries, but returns in local markets were more severe. Adjusted for inflation, the UK market didn’t break even until May 1987 and US investors didn’t see the same level until August 1993, over 20 years since the start of the sell—off. If you include fees, transaction costs and any applicable taxes, the situation became rather worse.

This is shown quite clearly in the fourth chart. Investors had long periods in the 1970s and the 2000s when they made substantial inflation—adjusted losses; think of a retired person drawing down their capital and the combination of falling markets, high inflation and withdrawals could lead them to a very perilous position relatively quickly.

MSCI World Total Return inflation—adjusted (GBP)

Source: IG Group, August 2018

What conclusions should we draw from this?

Firstly, stock markets can have precipitous declines when geo—politics takes control, or when equity markets simply get too far ahead of themselves. Couple either of these events with high inflation, and it could take a considerable amount of time to recover asset values.

Secondly, asset allocation matters. If you have a large purchase to make or are looking to retire, being 100% invested in equities is unlikely to be a sensible idea. Holding bonds will not protect you against inflation (unless they are index—linked, and even then only in certain circumstances), but rebalancing them into equities at lower prices is value accretive. We have written previously on safe withdrawal rates and whether it is better to buy an annuity or use drawdown, but the fact remains that forecasting the future is very difficult.

Thirdly, diversification is important. It may be tempting to put everything in one market, or product, but a more nuanced approach (such as in an IG Smart Portfolio) could result in a better investment experience. At present the US (62%) and Japan (8%) make up 70% of the MSCI World Index. The struggles of Japan are well known, but it is not inconceivable that the US at could start to underperform the rest of the world at some point, having hugely outperformed over the past decade. Holding a 62% concentration in a single country is a high risk strategy.

Lastly, investing is unpredictable. Just when you feel you are on track to retire your investments can be hit hard. To play it safe, it makes sense to over—invest where possible. If all goes well, you might be able to retire early but if it doesn’t a safety net will ensure that you have a greater chance of meeting your goals.

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