While recent volatility of American stock markets may worry some investors, market declines are a normal part of investing and part of the reason why stocks have a higher expected return than other investments.
Stock market declines in July and August, following last year’s losses in the last quarter of 2018 has renewed anxiety for some investors. While the media focuses a great deal of attention on daily price declines, volatility is simply a normal part of investing and a big part of the “risk” that “rewards” long-term investors in global markets. In the video link below, Nobel laurate Eugene Fama remarks that if “you have a long horizon over which you are going to be invested, then you don’t want to pay attention to the short-term.”
For investors who react emotionally during volatile markets — often inspired by increased media reporting and paying too much attention — timing the wrong response may be far more detrimental to their long-term results than any short-term drawdown impact.
INTRA-YEAR DECLINES ARE COMMON
Exhibit 1 shows calendar year returns for the US stock market since 1979, as well as the largest intra-year gains and declines that occurred during a given year. During this period, the average intra-year decline was about 14%. About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops during several years, calendar year returns were positive in 33 years out of the 40 examined. This exhibit shows just how common market declines are. Moreover, it also shows just how difficult it is to say whether a large intrayear decline that happens to occur will result in negative returns over the entire calendar year.
REACTING CAN NEGATIVELY IMPACT RESULTS
If you tried to time the market in order to avoid potential losses associated with periods of increased volatility, how much would this help or hinder your long-term performance? If current market prices aggregate the information and expectations of all market participants, then timing cannot systematically exploit stock mispricing. In other words, it is unlikely that many investors will successfully time the market, and when they do manage it, usually it is a result of luck rather than skill.
Further complicating the prospect of market timing being potentially additive to portfolio performance is the fact that a hugely disproportionate amount of total stock returns occurs during just a handful of days. Since few, if any, investors can reliably predict in advance which days will have strong returns and which will not, the prudent course is to remain invested during periods of volatility rather than move into and out of cash. Otherwise, an investor risks holding cash on those few days when returns become strongly positive.
Exhibit 2 helps illustrate this point. It shows the annualized compound return of the S&P 500 Index for 29 years beginning in 1990. It also illustrates the impact of missing out on just a few days with the strongest returns during all those years. The bars represent the hypothetical growth of $1,000 over the period — and what is lost by missing the best 1 day, best 5 days, best 15 days and best 25 days. The data shows that avoiding equity allocations for only a few of the best single days in the market would have resulted in substantially lower returns than the total period had to offer — in fact, if you missed the best 30 days of that 29-year period, the realized return from such an equity investing strategy only would be equivalent to risk-free one-month US T-bills!
While market volatility can be stressful for some investors, reacting emotionally and changing a sound long-term investment strategy in response to short-term declines lasting even a year or more could prove far more harmful than helpful. By adhering to a professionally developed investment management process, with an investment policy agreed upon in advance of volatile times describing the potential ranges of potential declines, investors may be better able to stay disciplined during those inevitable periods of short-term uncertainty. Conversations with a CFP® professional may help.
In a bit of practical advice, Professor Fama admonishes below: “You’re better off if you just don’t look. Basically, don’t pay a lot of attention to what is going on in the markets.”
When markets are messy and he’s not doing research or writing, Gene is known to go out and play golf or tennis. Maybe you should too.