Well that was exciting! Until this month’s ~10% “correction” in world equity markets, volatility had fallen so far below historical averages that stock market movements had almost begun to resemble the relative tranquility of fixed income markets. For months on end, equity returns were generally positive and steady – in fact, the S&P 500 did not experience a single negative month in all of 2017 (something that has never occurred before in any prior calendar year on record). In that kind of environment, investors could be forgiven for becoming a bit complacent! And it’s no surprise that after such a long period of relative calm, a sudden 10% move to the downside can feel quite unsettling.
Unsettling perhaps, but not unexpected. According to InvesTech Research, the S&P 500 index has experienced a 5% drawdown about every 7 months, and a 10% decline about every 26 months since 1932. (Larger declines of 20% or more occur about every 3.8 years, on average). Since the latest “bull market” began in March of 2009, the S&P 500 is up nearly 300% despite suffering five separate corrections of 10% or more.
As evidence-based investors, we know to expect volatility. This month’s stock market gyrations offer us a good reminder of not only why stocks are volatile, but also how we can use volatility to our advantage in portfolio management:
- One reason that stocks are volatile is that they are a claim on a very long stream of income to be received in the future. The cash flows (dividends) are themselves uncertain, and also must be “discounted” at an interest rate that is also uncertain and always evolving. The combination of these two factors explains much of the movement in equity prices over time.
- While periodic draw-downs in the stock market are entirely expected, their timing is also completely unpredictable. Missing just a few of the best stock performance days would have a severe and detrimental impact on your long-term returns. Market timing strategies are rarely successful, even for professional investors, and tend to incur high trading costs as well.
- Volatility provides an opportunity to rebalance our portfolios, by selling a portion of recent winners and reinvesting in other asset classes at lower prices. This maintains the target risk profile of the portfolio and can help to enhance long term returns.
- Without volatility, future stock returns would almost certainly be a lot lower. Why? Because risk and return are related. If you eliminate the former, you’ll certainly have an impact on the latter. Volatility can be thought of as the price we pay for positive, inflation-beating long-term returns.
- Volatility in one asset class reminds us of the importance of owning a diversified portfolio. A well-constructed portfolio will hold several asset classes, and should include lower risk, short-term bonds, which act as a kind of ‘shock absorber’. Importantly, it is the risk of the overall portfolio, not the S&P 500, which should matter to investors.
While the timing is entirely unpredictable, volatility is also normal, expected and potentially useful. Bouts of volatility can certainly be unsettling at times, but it is nothing to be feared. Before volatility returns again, investors might be better able to ride out future market fluctuations if they have prepared their portfolios, and their minds, for what to expect (and how it might feel!) In this way, they will also be able to remain focused on their long-term strategy for meeting well-defined goals and growing their wealth over time.