Does Your Portfolio Embrace Market Volatility?

Matthew Unger |

Many investors, especially those still reeling from the 2008 – 2009 stock market roller coaster ride, have developed a low tolerance for volatility. Not to mention the seven corrections of 10-20% we have had since then. As a result they have moved a significant portion of their investments into bonds or other fixed yield vehicles. What many investors may not realize is that wholesale switches from one asset class to another in order to avoid volatility can actually increase it and put them further away from achieving their goals or in some instances derail them entirely. Secondly, for investors with a long-term perspective on their investments, volatility is actually a good thing, as it is the primary driver behind the sustained market gains over the last century. Remember, volatility is measured in both directions - not just downward, but upward.

Unquestionably the stock market has experienced some fairly severe volatility in recent years, and 2018 was no exception. But a more thorough review of the historical record provides a clearer perspective on market volatility over the decades that actually favor investors who manage to hang on even in the worst of market declines. (Fact: Did you know 2017 had the lowest volatility since 1965, while December 2018 was one of the most volatile on record?)

Winning with Market Volatility

Since World War II, the stock market has experienced, on average, an intra-year decline of 14 percent each and every year; and in that same period, the market ended lower, on average, by 18 percent every third year. Remember 1998? A 20%+ correction occurred in October, but the S&P 500 ended up well over 25% on the year. Bear markets, with an average decline of nearly 30 percent, have occurred every fifth year. Yet, over that same span of nearly seven decades, stock market values have grown 100-fold, which means that, $1,000 invested in the stock market 70 years ago would have grown to $100,000 despite the periodic market declines.

Corrections are like sever thunderstorms, they come quickly and don't feel very good, but they disappear almost as quickly as they appear. Bear markets are more sinister, they strike when almost no-one expects it, but not unlike hurricanes one can spot a bear market and prepare accordingly if they know the right places to look. That said, don't fall prey to firms that promise to call every bear market. It simply isn't realistic nor responsible to make such claims.

The very profound and highly instructive take away from this is that market declines have, thus far, been nothing more than a momentary interruption in an enduring market advance. Hence, volatility is simply a necessary phenomenon of a market that works. On the other hand, market risk – the risk of incurring losses as stock prices fall – is human-induced. The only way investors actually lose money is when they sell their stocks.

Warren Buffet has said that stock markets are efficient at transferring wealth from the patient to the impatient. All it takes is one bad decision and one can seriously put themselves into a precarious situation and end up having to go back to work during retirement.

Those who are suddenly spooked into bailing out of the market after it has already fallen 10 or 15 percent, will almost always lose money. Yet, history shows that the stock market rewards investors who can bear the volatility of stocks and avoid the harmful behavioral traps through various periods of performance.  So, the real risk to investors isn’t being in the next 20 percent market decline, its being out of the next 100 percent market increase. After all, US markets are up 74% of the time, and 20%+ of those times, it is up by double digits.

Building Your Portfolio around Market Volatility

Proper Diversification

Proper diversification is the key to withstanding increased volatility and reducing downside exposure. A well-diversified, strategically allocated portfolio will almost always decline in value less than the stock market indexes over time. That's not to say there won't be individual years of outperformance and underperformance, but performance is part of the entire wealth management equation. If your portfolio only declines 7 percent while the stock market declines 12 percent, you’ll have less to recover when the market rebounds. While theoretically one would like to outperform markets every year, unless you are looking to a hedge fund strategy, this will happen from time to time, and certainly is not the proper expectation to have year after year.

Focus on your Long Term Objectives

During periods of increased market volatility it does little good to worry about the market-shifting macro events of the day that will have little or no impact on the long-term performance of your portfolio. The stock market decline of 2008 will turn out to be nothing but a small blip for a portfolio invested for 20 years.  It took years for the investors who fled the market in 2008 to recoup their losses, while those who kept their sights on their objectives and stayed the course have enjoyed record gains in their portfolio. Many individuals waited a decade to get reinvested. The opportunity cost of such behavior was devastating to individuals, and still follows them until this day.

Patience and Discipline

Volatile markets can cause investors to make costly mistakes, such as trying to time the market (which is very difficult at best), or chasing performance, or trying to pick the winners. These mistakes can cost investors a significant portion of their portfolio value. It takes patience and discipline to adhere to a strategy and avoid the herds. Stocks should be deliberately bought and sold according to a strategy, not in response to emotions.

Missing the Rally

A common misconception, and often a devastating one, is that going through a bear market will ruin you. It is well known statistically that the biggest risk to an investor is not being caught in a rut or a bear market, but missing out on the rally. Selling while market are up could potentially lead to further losses than selling while the market hits a bottom.

 

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites in conjunction with Focus Asset Management to provide information on a topic that may be of interest. Copyright 2014-2015 Advisor Websites.