Stock Market Volatility Rears its Ugly Head Again

February 9, 2018

 

Two years ago we wrote about stock market volatility as 2016 began with the worst start for stocks in a calendar year in history. 2018 began with one of the best starts in history; and in February once again volatility stormed back into markets.  Keep in mind, in 2017 stock market investors experienced one of the lowest amounts of volatility in history.  That was the unusual part.

 

Let's examine some facts courtesy of Dimensional Fund Advisors.

 

In the first 6 trading days of February 2018, the US market (as measured by the Russell 3000 Index) fell over 10% (commonly referred to as a "correction"), resulting in many investors wondering what the future holds and if they should make changes to their portfolios. 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 drawdown itself.

 

INTRA-YEAR DECLINES

 

Exhibit 1 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 about 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 out of the 37 examined. This goes to show just how common market declines are and how difficult it is to say whether a large intra-year decline will result in negative returns over the entire year.

 

Exhibit 1. US Market Intra-Year Gains and Declines vs. Calendar Year Returns, 1979–2017

In US dollars. US Market is measured by the Russell 3000 Index. Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

 

REACTING IMPACTS PERFORMANCE

 

If one was to try and 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, stock mispricing cannot be systematically exploited through market timing. In other words, it is unlikely that investors can successfully time the market, and if they do manage it, it may be a result of luck rather than skill. Further complicating the prospect of market timing being additive to 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 jump in and out of stocks. Otherwise, an investor runs the risk of being on the sidelines on days when returns happen to be strongly positive.

 

Exhibit 2 helps illustrate this point. It shows the annualized compound return of the S&P 500 Index going back to 1990 and illustrates the impact of missing out on just a few days of strong returns. The bars represent the hypothetical growth of $1,000 over the period and show what happened if you missed the best single day during the period and what happened if you missed a handful of the best single days. The data shows that being on the sidelines for only a few of the best single days in the market would have resulted in substantially lower returns than the total period had to offer.

 

Exhibit 2. Performance of the S&P 500 Index, 1990–2017

 

In US dollars. For illustrative purposes. The missed best day(s) examples assume that the hypothetical portfolio fully divested its holdings at the end of the day before the missed best day(s), held cash for the missed best day(s), and reinvested the entire portfolio in the S&P 500 at the end of the missed best day(s). Annualized returns for the missed best day(s) were calculated by substituting actual returns for the missed best day(s) with zero. S&P data © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. One-Month US T- Bills is the IA SBBI US 30 Day TBill TR USD, provided by Ibbotson Associates via Morningstar Direct. Data is calculated off rounded daily index values.

 

CONCLUSION

 

While market volatility can be nerve-racking for investors, reacting emotionally and changing long-term investment strategies in response to short-term declines could prove more harmful than helpful.  Diversification and patience are the best weapons against the irreducible uncertainty of investing in equity markets.

Please reload

Newsletter

Subscribe to our newsletter to stay up to date on investment and wealth management news

Recent Posts
Please reload

Archive

You might also enjoy reading:

How to Beat the Short-Term Market Jitters

September 6, 2019

Stock Prices are High - What Does that Mean for Future Returns?

September 6, 2019

What is an Inverted Yield Curve and Why Should I Care?

September 6, 2019

1/10
Please reload

Please reload

Search By Tags