Managing through Volatile Markets
Chief Investment Officer
“Only by selling stocks will you turn a temporary stock market drop into a permanent loss in your portfolio.”
Volatility is back. The stock market’s mostly smooth climb higher since 2012 was interrupted this past quarter with stock prices, at the worst point, declining by 10% over the course of just four days.1
Volatility, of course, is defined by price movements in both directions, to which the market complied with large single-day fluctuations throughout the quarter’s second half. Not that investors ever fret over the upside of volatility, rather it’s the drops that cause anxiety. This quarter we look at what is normal stock market volatility, along with why you should avoid market timing and instead employ an asset allocation strategy to navigate the market’s fluctuations.
What is “Normal” Volatility?
The stock market’s use of an auction process to set prices will always lend itself to volatility. But what amount of volatility is considered normal? And, more importantly, how large of market declines should you expect?
To answer these questions, we looked at the size of each year’s largest intra-year, peak-to-trough stock market declines during the period of 1980 to the present. We then grouped the declines by size. The results are shown in Figure 1.
Most common during the period were declines of 6% to 15% which occurred in about 60% of the years measured. These dips were typically associated with some type of negative news, but did not coincide with an economic recession. While common, dips of this magnitude can be unsettling as they leave investors wondering if the dips will become more severe.
1As measured by the S&P 500 Index®
Not so common are years when prices fell no more than 5% at any point. While investors may welcome these stable years, they have occurred only twice in the past 36 years and are outside the range of normal volatility. At the other end of the spectrum are years that experienced drops of 26% or more. Declines of that magnitude occurred six times, or 14% of years. These larger drops, with the exception of 1987, coincided with economic recessions.
What should not be lost in this review of market declines is that the stock market was very rewarding to investors during the period measured. In fact, stock prices rose at an annual rate of 8.4% throughout the period. If you include reinvested dividends, the annualized return rises to 11.4%. Thus, the market’s rallies were far greater than its dips.
Dealing with Volatility
All of us would like to enjoy the rewards that come from investing in stocks without having to suffer through the dips. Yet, when you invest in stocks, periodic dips are part of the package. How you manage the market’s volatility is crucial to accumulating long-term wealth.
Many investors have tried unsuccessfully to time their market exposure in an attempt to capture the gains and avoid the declines. But as anyone who has tried this knows, doing so with the required levels of both accuracy and consistency is virtually impossible. Successful market timing requires that you accurately predict both the timing of a decline and its magnitude in order to exit and reenter the market at the correct times. Yet, there is no way to know precisely when a market will begin a decline or, once a decline has begun, how deep it will go. And being wrong on either prediction can cause your returns to be worse than if you simply stayed invested.
A better way deal with the stock market’s volatility is to diversify your portfolio by investing a portion in other, less volatile, asset classes such as cash, bonds, and non-traditional assets.
You should invest into stocks only that portion of your portfolio that you can hold for an extended period of time—which we define as 10 years or longer. By holding other assets, you will always have an alternative to stocks from which to raise cash should you need it during a stock market decline. The importance of avoiding stock sales during declines cannot be overstated. Only by selling stocks will you turn a temporary stock market drop into a permanent loss in your portfolio.
The ability to raise cash without selling stocks is not the only benefit of holding other asset classes during a stock market decline. A diversified strategy also allows you to profit from the stock market’s temporary dips through the discipline of rebalancing your portfolio in accordance with your established asset-allocation targets. During stock market declines, the process of rebalancing will require that you reallocate money from other asset classes into stocks, thereby taking advantage of the lower prices available. This strategy can add significantly to your long-term wealth if done in a disciplined manner over the course of numerous stock market declines. This is perhaps the best way you can turn the stock market’s volatility into a benefit instead of just a source of anxiety.