After almost two years of relative calm, in recent days a violent unforeseen increase in stock market volatility around the world has caused anxiety for many investors.
From February 1–5, the US market (as measured by the Russell 3000 Index) fell almost 6%, resulting in many investors wondering what outcome the future holds. Should investors be “smart” and change their portfolios, and perhaps maybe “take some profits” to avoid the pain loss? While remaining calm during any substantial market decline may be difficult when daily “noise” from newscasters may be loud and hard to ignore, it is important to remember that volatility swings are not only normal, but inevitable. Additionally, reacting emotionally to volatile markets and suddenly moving substantial portions to cash or bonds may easily be more detrimental to long-term retirement outcomes than the drawdown itself. Recoveries frequently occur with what seems in hindsight, lighting speed.
Exhibit 1 shows calendar year returns for the US stock market since 1979, as well as the largest intra-year decline that occurred during that calendar year. During this period, the average intra-year decline was about 14%. About half of these years had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops, calendar year returns were positive in 32 years out of the 37 examined. This shows just how common market declines are and how difficult it is to predict whether a particularly large intra-year decline will result in a negative outcome for that year.
Exhibit 1. US Market Intra-Year Gains and Declines vs. Calendar Year Returns, 1979–2017
Reacting Impacts Performance
Imitating professional traders and reacting to the latest newscasts, there are legions of retail investors trying to “time” market movements in order to avoid losses associated with periods of increased volatility. Should those activities be expected to help or hinder long-term outcomes? If current market prices aggregate the information and expectations of all market participants, as academic research implies, stock mispricing cannot be systematically exploited through market timing efforts. In other words, it is unlikely that investors can enhance returns timing the market. For the few that do manage it, it is almost always luck at work rather than skill. Smart investors don’t gamble with their retirements.
Further complicating the dim prospects of market timing activities enhancing long-term portfolio performance is the fact that a substantial proportion of stock total return comes from just a handful of days. Few investors (if any) are likely to identify in advance and systematically those days having strong returns. The informed strategy is to remain invested (or even modestly add to market positions) during periods of negative volatility rather than futilely jump in and out of stocks. Otherwise, an investor risks being sidelined in cash on days when returns happen to be strongly positive. Nothing creates stress like holding cash as a bull market surges and most of your buddies are invested.
Exhibit 2 helps illustrate this point. It shows the annualized compound return of the S&P 500 Index going back to 1990, and then shows the negative impact of missing up to 25 days of the best market returns. The bars represent the hypothetical growth of $1,000 over the period. We see the results of missing the best single day during the period and the gains lost missing the best 5, 15, and 25 single days. Being out of the markets for only a few of the best single days would have resulted in substantially lower realized returns than comparable model returns if continuously invested. While not illustrated below, for would-be timers unlucky enough to miss the 40 best days over the last forty years, the realized S&P 500 Index return could drop to about zero. (Given the prevalence and variety of timing activities, no surprise then, that multiple academic research studies suggest that the typical investor, on average, experiences long-term performance after costs close to the “risk-free” one-month US T-bill return.)
Exhibit 2. Performance of the S&P 500 Index, 1990–2017
While market volatility can have painful memories for those who endured a major market crisis like the Tech Bust or the Global Financial Panic, reacting emotionally and changing sound investment strategies in response to episodic short-term declines usually negatively impacts wealth accumulation. By trying to avoid market risk, fearful investors miss the full and fair returns that markets have to offer. By instead adhering to a professionally managed investment strategy, planned well in advance of inevitable market turmoil that considers their risk preferences and circumstances, disciplined investors may have greater confidence, and experience less anxiety during episodes of uncertainty and crisis.
The importance of having an customized wealth management framework cannot be overemphasized. An acknowledge professional with a proven process and a network of experts in finance, accounting, tax and law specializing in working with successful families like yours, can develop an informed integrative process for retirement planning. A professionally structured process will put you in control of your family’s future, and guide smart decision-making. By avoiding costly mistakes you never imagined, you are far more likely to experience the abundant retirement lifestyle you’ve dreamed about, and hopefully leave a legacy for family, community, and causes you care deeply about.
Source: Dimensional Fund Advisors LP.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to a wealth management professional prior to making any investment decision.
Investing involves risks including possible loss of principal. Stocks are subject to market fluctuation and other risks. Bonds are subject to increased risk of loss of principal during periods of rising interest rates and other risks. There is no assurance that any investment strategy will be successful. Diversification does not assure a profit or protect against loss.