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What is volatility?
Market volatility is expected when an investor uses their funds in the hopes of gaining a long term positive expected return. Volatility refers to the amount of uncertainty or risk related to the particular asset or combination of assets. A higher volatility means that a security one is investing in is riskier than that of other assets. With higher volatility one can expect that the price of the security can change dramatically over a short period of time in either direction. A lower volatility means that a security does not fluctuate in value as dramatically but will likely have lower expected returns.
An investor will use a combination of securities to diversify away significant amounts of market volatility. Using a combination of stocks and bonds should help reduce portfolio volatility and help an investor stay calm during periods of heightened market volatility.
Stock market slides over a few days or months may lead investors to anticipate a down year. But a broad US market index had positive returns in 15 of the past 20 calendar years, despite some notable dips in many of those years.
Intra-year declines for the index ranged from 3% to 49%.
Calendar year returns improved on those intra-year slides. The steepest declines saw notable recoveries, and in 15 of the 20 years, stocks ended up with gains for the year.
Even amid the financial crisis in 2009, a 27% plunge gave way to a 28% gain by the end of the year
What should you do with your investment portfolio?
Today, we are in a time of heightened volatility and many of our conversations with client’s center around what is going on in the market and what they should be doing with their portfolio.
A common question some may have asked themselves over the past few weeks is, “Why don’t we just sell everything and wait this out? Get back in the market when the dust settles?
We understand this concern, the economic effects of the COVID-19 cannot be argued. There is nowhere to point to as a signal of “all clear” everyone buys back in. If only it were that simple. When the dust settles, do you think stocks will be at their lows? Or will they have already rallied in anticipation of this? Look at history. On March 9th, 2020, 11 years ago to the date, in 2009, the stock market stopped going down. There was no reason for this. The dust had settled, without fanfare or any sort of official announcement. If you had polled people around that time, most would not agree that we had seen the worst. The economic headlines were not improving, forecasters were calling for worse. Well…. Those who tried to time the market, likely lost big. From March 9th until June 1st, 2009, the stock market climbed 41% from that March low. Those who had cash were still sitting on the sidelines as the markets were seeing new highs, it was foreseen as too risky to buy back in after what was just experienced. They missed out on new record highs, hundreds of basis points in compounding on their assets.
What is going on regarding COVID-19 is very real and something we do not take lightly. The virus is likely going to get worse, as is the economy. What is sometimes forgotten when looking at the market is the fact that markets are forward looking. Markets anticipate and respond to information in real time processing, anticipating and acting as it becomes available. Markets have seen significant moves in both directions recently and we must recognize that the markets will and have taken significant hits in advance of the economy. We are going to see unemployment numbers rise, sales in many industries decline significantly and the news around the virus dominate our media channels. But, let’s remember, like March of 2009, the news that dominates our channels may still focus on the negatives in regards to our health and the economy, and we do not know when things will get better but we do know that the market will anticipate the positives and react before we can try to time the ride back up. Focus on what you can control, find a sensible investment approach.
Our investment philosophy is built around principles and academic science. We do not follow trends, fads or the exciting pick of the day style of asset management. We know that attempting to pick one stock over another, time the market, or chasing the trends has proven to not work over the long term. Our approach to wealth management views the market as an ally, not an adversary. We look to capture returns of the markets across the globe using low cost approaches to asset management.
As discussed above, the events of COVID-19 are truly unprecedented. As we have discussed in the past, watching the news on a day-day would have given many investors a sense of fear of what could happen to their assets. With volatile markets comes positive days and significantly positive some days. Controlling investor behavior becomes a huge part of every advisor’s job during periods like this. Market timing is nearly impossible, but having an investment portfolio that is low cost, globally diversified, structured along the dimensions of expected returns and meets an investors particular asset allocation will lead to long term success.
Research by people like Kahneman and Tversky on loss aversion shows losses make us feel worse than gains make us feel good by a factor of approximately 2.5-to-1. We think those numbers are severely understated when talking about big losses. Many of us felt this over the past couple months as the reporting of the terrible days the market has had were well documented, while the positive days are something we seem to forget about.
All the research tells us that the best thing to do at points like this is to stay invested. Depending on risk tolerance, each investor has a strategic asset allocation. For those less risky investors, the fixed income portion of your portfolio has done its job since the stock market’s peak. Long term treasuries have increased significantly as yields have plunged. At points of volatility, an investor may want to re-consider asset allocation and take on less risk but at no point will it be a prudent decision to exit the markets. We know that missing the best days of trading significantly hurts long term performance. The best days often come in periods of heightened volatility.
There are reasons to take risk, and risk pays off, but risk comes with volatility. As we have said in the past, we want to remind everyone that the markets are designed to handle uncertainty, processing information in real-time as it becomes available. We cannot tell you when things will turn or by how much, but our expectation is that bearing today's risk, one will be compensated with positive expected returns.
Find below a graph produced by Dimensional Fund Advisors looking at market returns following market declines.
Source: Dimensional Fund Advisors
https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/loss-aversion/
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