Remaining Invested through Market Volatility

Market volatility is an investment term that describes a period of unpredictable and sometimes sharp movements in price of a market or asset. While the term is neutral, suggesting either higher or lower price movements, it’s usually employed to describe price declines or market selloffs.  

Market professionals’ aversion to explicitly label a market downturn is indicative of investors’ general aversion to lower asset prices. So much so, that we don’t like to hear or see the words! This is understandable, as lower prices usually lead to negative returns, which in turn lead to unhappy investors and clients.  

So, for most investors, market volatility is an unpleasant experience. To avoid such unpleasantness, investors have the impulse to sell out of the market or cut one’s losses—a physiological flight response, as if your financial portfolio was a buffalo at a waterhole, and the current capital markets a crocodile. However, statistical evidence suggests that your sympathetic nervous system is not the best source of financial advice. 

Firstly, large or sudden drops in capital markets are not uncommon. No doubt you’ve probably come to appreciate that declines are part of the normal course of investing. For example, let’s consider price movements for the S&P 500, the world’s largest equity index, from 1948 to 2017.  During that period, a decline of 5% occurred about 3 times a year; a decline of 10% occurred about once a year; a decline of 15% about every 3.5 years; while a decline of 20% occurred every 6.3 years.  

While not uncommon, volatile periods are still difficult to navigate, even for the most seasoned investor. Avoiding market downturns or selling at the highs to buy back in at the lows, is notoriously challenging, and sometimes a matter of some luck as well as foresight.

Missed opportunities

Even the most sophisticated investor cannot anticipate market movements; although some might have their clients believe otherwise.  Politics, monetary policy, fiscal policy, economic activity, global pandemics, and geopolitical shocks are just a handful of factors, each extensive in their own right, with varying degrees of effect over price movements. Some of these can be anticipated while others are of course entirely unpredictable.  

If an investor’s timing is not perfect or near-perfect, they miss out on potential rallies.  Two major data points describe this precariousness of timing the market.  Firstly, the market’s best days typically follow the largest drops. For example, between 1929 and 2011, the S&P 500 average 12-month return immediately following a 15% or greater decline was….. 55%! Which suggests that panic selling is associated with missed opportunities to the upside.  

Secondly, missing even a few days of positive market activity can have a profound impact on one’s portfolio.  If an investor missed the best 10 days of higher price movements over the last 10 years for the S&P/TSX Composite ending December 31, 2020, their portfolio would underperform by approximately 40%. Missing the best 20 days over the same 10-year period would translate to an underperformance of about 55%.

Focus on the long term

As already implied, while markets may seem pessimistic during periods of heightened “volatility” they often bounce back relatively quickly. Despite averaging a double-digit correction per year, the S&P 500 has finished with positive returns in 31 of 41 calendar years.   

Similarly, likelihood of negative long-term returns with an effectively diversified balanced portfolio (60% stocks and 40% bonds) is historically very low. Based on rolling returns, such a global balanced portfolio of stocks and bonds has not produced a negative return over any five-year rolling period between 1979 to 2020. 

Ask yourself, will the market be higher 1, 3, or 5 years from now? Most investors would answer ‘yes’, and the data overwhelmingly supports that answer.  

Volatility equals opportunity  

Major price fluctuations provide money managers the opportunity to better position portfolios, given that part of the return calculation of an asset is its entry price.  Market crisis can push prices artificially low, despite an asset’s long-term prospects, creating excellent buying opportunities. Active managers through thoughtful portfolio construction can adjust portfolios to be better positioned over the long term.

And finally

If the past few years have taught us anything, it is that the markets always give investors something to be concerned about. No year goes entirely right. Which is not to dismiss our prevailing risks, but to appreciate that markets right themselves as they better understand risks, and as those risks ultimately change and pass. Thus, with a well-diversified portfolio in hand, one’s best approach is to focus on the long-term and appreciate the noise for what it is just noise.