After a sustained period of relative calm in the markets in 2017, in recent weeks there has been an increase in volatility which has resulted in renewed anxiety for some investors.
While it may be difficult to remain calm during a substantial market decline, it is important to remember that volatility is a normal part of investing. Additionally, for long-term investors, reacting emotionally to volatile markets may be more detrimental to portfolio performance than the draw down itself.
THE OLD NORMAL
The graph below shows calendar year returns for the US stock market since 1979, as well as the largest intra-year declines that occurred during a given year. During this period, the average intra-year decline was approximately 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, calendar year returns were positive in 32 years of 37 years. This shows how common market declines are and how difficult it is to predict if a large intra-year decline will result in a negative annual return.
If the recent fall in value was ‘normal’ what was all the fuss about? Why did a reputable Irish paper lead with the headline “Pensions blow as Wall Street shock wipes $4 trillion” and have articles with headlines like “Plunge has inevitable echoes of 2008 crash”, when historic data shows corrections of this magnitude occur on a relatively regular basis.
If one was cynical, they may suggest the media’s objectives are not aligned with providing financial advice that is in an investors best interest? Maybe the newspaper was trying to just sell newspapers? An understandable objective for any good editor. An analogy I heard recently from a UK adviser sums it up, “The plane that lands is not news, the plane that crashes, that is news”.
On average a 10% fall in US equity markets happens every two years
REACTING AFFECTS PERFORMANCE
While it may be easy to understand the media’s analysis has potential biases, it is difficult to avoid it in this day and age as TV, newspapers, social media, smart phones etc. all add to the hype and constant flow of information from 'experts' predicting the future. If you were an investor who didn’t panic congratulations, not everyone has this disciplined approach to investing.
If one was to react to the media and try to time the market in order to avoid the potential losses associated with periods of increased volatility, would this help or hinder long-term performance?
If current market prices aggregate the information and expectations of market participants, it is very difficult for stock mispricing to be systematically exploited through market timing. That is not to say you may get lucky from time to time, but on an ongoing basis, it is very difficult to consistently time the market to benefit a portfolio through skill.
Further complicating the prospect of market timing being a positive for portfolio performance is the fact that a substantial proportion of the total return of stocks over long periods comes from just a handful of days. Since investors are unlikely to be able to identify in advance which days will have strong returns and which will not, the prudent course is likely to remain invested during periods of volatility rather than trying to time the market by moving in and out of equities. Otherwise, an investor runs the risk of not being invested in the market on days when returns happen to be very positive. The next bar chart shows the negative impact missing some of the best days can have on a portfolio’s long-term return.
The chart shows the value of $10,000 invested in the S&P 500 between January 1, 1997 and December 30, 2016. Over the 20-year period, if you missed out on the 20 best days, it had a detrimental impact on your average annual rate of return. For the period assessed it would reduce the average annual return by 6% per annum or 302% on a cumulative basis.
It is also interesting to note that over the same period, six of the best 10 days occurred within two weeks of the 10 worst days (for example the best day of 2015 – August 26 – was only 2 days after the worst day – August 24). At the time of writing this article, two weeks after the reported plunge in global stock markets in early 2018, another Irish paper was reporting global stocks were set for their best week in six years.
While market volatility can be nerve-racking for some investors, reacting emotionally and changing long-term investment strategies in response to short-term declines could prove more harmful than helpful. By adhering to a well-thought-out investment strategy, developed based on a holistic financial plan, investors may be better able to remain disciplined during periods of short-term uncertainty, thus avoiding inferior returns due to poor investor behaviour.
Data Source: Dimensional Fund Advisors LP. JP Morgan Asset Management.
The views and opinions expressed in this article are those of the author. Distinct Wealth management (DWM) accepts no liability over the content or arising from use of this material. The information in this material is provided for background information only. It does not constitute investment advice, recommendation or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision.