Managing Volatility, Losses, and Expectations in Today's Market
BY: Daniel M. Savage
Stock market volatility and attendant anticipation of possible losses have once again reared their ugly heads.
After three consecutive years of significantly higher-than-average returns, the S&P 500 and other equity indices are off to a shaky start. Given how strongly equity markets have recovered since the 2008–2009 financial crisis, one might easily forget that volatility (i.e., risk) and losses are a normal part of investing life.
To help understand why, let’s take a closer at how domestic large company stocks, as defined by the Ibbotson Large Company Stock Index, performed over the longer term, from 1926 through 2021. Here are several key metrics and observations (all per Morningstar):
- The compound annual return is approximately +10.3%
- The highest 12-month rolling period return was +162.9%
- The lowest 12-month rolling period return was -67.6%
- Negative returns occurred just over 24% of the time
- Those highest and lowest returns are typically moderated through the addition of bonds to a portfolio and/or longer holding periods.
Returning to the 2008–2009 financial crisis, we see a markedly different pattern as follows:
- After a 37% loss in 2008, 12 of the next 13 years produced positive returns.
- 10 of those 12 positive returns were considerably above the compound annual return of 10.3% noted above; the other two were considerably lower.
- The lone negative (in 2018) return was -4.4%.
- Observable volatility since 2009 was limited to daily, weekly, and monthly occurrences, something either overlooked or quickly forgotten by many investors.
So, how might investors better cope with what may be resurgent volatility?
- Revisit your tolerance for risk. Return maximization isn’t for everyone, because it's closely associated with greatly increased potential for volatility. Here’s a clue: If you’re checking your investment balances weekly or daily, your risk tolerance and portfolio structure are probably misaligned.
- Review your time horizon. How old are you? When do you plan to retire? Do you anticipate large expenditures in the near term? These are important questions, because when it comes to volatility, time can be an investor’s good friend – the longer the time period, the better the friend. Referring back to the lowest 12-month rolling period return noted above, that number improves to a -17.4% return for 60-month holding periods.
- If possible, broaden (improve) portfolio diversification. Volatility and portfolio concentration are strongly correlated, so consider adding/increasing exposure to other asset classes, such as bonds and cash, as well as sub-classes. Doing so will generally decrease volatility and may improve performance, in some cases.
- Don’t be reactive. Media, experts, family, and friends all have advice for us, and it's rarely consistent. Instead of reacting, make sure you have a well-conceived investment plan that fits your circumstances, is consistent with your risk tolerance, and advances your longer-term objectives. Frequent changes made for the wrong reasons will undermine your financial well-being.
- Work with a trusted, seasoned Wealth Manager or Advisor. There is no substitute for sage advice from someone who puts your best interests first.
In summary, stock market volatility has always been and will continue to be with us, but it can be successfully navigated. As Warren Buffett said, “Risk comes from not knowing what you’re doing.”