Equity market highs: The power of staying invested

03 July 2024
by Derek Bilney

Equity markets regularly reach new record highs, but this alone is not a definitive signal to sell. Historical data shows that investment returns in the year following a record high are typically around 10%, suggesting that staying invested can be beneficial. However, many investors fall prey to the ‘Disposition Effect’ (also known as ‘Loss Aversion’), an investor bias that leads some to sell their ‘winners’ too early and hold onto their ‘losers’ for too long.

Currently, the S&P/ASX300 is nearing record highs, mirroring the trend in global markets, with benchmarks like the S&P 500 and NASDAQ also hitting all-time highs. Recently, the popular Dow Jones Industrial Average reached a new milestone of 40,000 points, capturing significant media attention despite its limitations as a benchmark. Even long-suffering UK and Japanese investors are seeing their benchmarks approach historic highs, providing a sense of optimism in those regions.

Despite these high points, market highs can often lead to a sense of uncertainty among investors, leading them to question has the market run too hard, too fast? Is it due for a fall? Should I sell and take profits?

Figure 1: Frequency of S&P/ASX 300 record highs (monthly data)

Record highs aren’t necessarily followed by lower returns

Looking at historical trends can offer investors valuable insights. Figure 1 shows the frequency of record highs in the Australian equity market each year. The year 2004 stands out as a ‘clear winner’, with markets reaching record highs 35 times as they recovered from the dot-com bubble and the China resources boom gathered momentum. However, record highs are not uncommon as the market has hit record highs nearly every year with the notable exception of an extended recovery period following the Global Financial Crisis (GFC).

So, record highs are not rare, but what about equity returns one year after a record high?

The data offers encouraging news: the S&P/ASX300 is typically higher. The median one-year return following a record high is 9.8%, with an average return of 8.9%, aligning closely with the benchmark's average annual return of 9.6%. This indicates that hitting a record high does not necessarily imply lower returns going forward.

Our investment process: avoiding investor biases

Enter, the ‘Disposition Effect’. An investor bias, which causes investors to prematurely sell ‘winners’ while holding onto ‘losers’ and can be detrimental to long-term investment performance. This effect is also observed at the individual stock level.

Our investment process incorporates sentiment-based signals to help profit from this common bias which can lead to investors selling outperforming stocks too soon. Sentiment, also known as Momentum, has been shown to be one of the strongest signals in the Australian market.

The Macquarie Australian Shares Fund includes stocks like QBE Insurance (QBE), Origin Energy (ORG), and Xero (XRO), which currently score highly on sentiment-based measures.

Similarly, the Macquarie Australian Small Companies Fund holds positions in Life360 (360), SmartGroup (SIQ), Ramelius Resources (RMS), and Service Stream (SSM) which currently score well in the small-cap universe. In both cases, positions are subject to change as opportunities evolve.

The Disposition Effect is one of the many investor biases that our investment process looks to profit from. Weekly data is collected for each stock and used to identify the most attractive investment opportunities. A diversified portfolio is then constructed that reflects a range of biases and risk considerations. The process is highly systematic and demonstrates the value of maintaining a disciplined investment approach and leveraging robust analytical tools to inform decision-making.

Time in the market vs timing the market

Ultimately, these insights reinforce a fundamental principle of successful investing: time in market is often more critical than timing the market. While it can be tempting to react to short-term market fluctuations, a long-term perspective tends to yield better results.

While record highs in equity markets can create a sense of unease, previous market cycles and behavioural finance principles suggest that staying invested is generally a more beneficial course of action. Understanding investor biases such as the Disposition Effect, can help investors better navigate market highs and position their portfolios for long-term success.