Expertly Riding the Waves of Volatility
We have prepared this piece to reiterate what we should all know, understand, and believe if we are going to own stocks in our portfolios. We look forward to continuing to educate you to help you stay well-informed and continue to watch our financial markets closely.
Why do we invest in stocks?
Quite simply, the reason we invest in stocks is because over the last 100 years they have illustrated again and again that if you invest for the long-term that you will, on average, receive about a 10% annual average return. This 10% return is about 40-50% higher than the return from bonds and about 50-60% higher than the returns from cash over that same 100 year period. Arguably, the excess returns over bonds and cash will be higher in the low interest rate environment we have become accustomed to for some time now.
What is the price for the higher returns that stocks deliver?
The price investors pay for higher equity returns is volatility. Stock investors experience return volatility because even though the average is 10%, it is clearly not 10% per year. In some years returns are better than average, like 2017 (up 21%) and in other years they are awful, like 2008 (down 38%). Stock investors accept the fact that, on average, about seven to eight out of every ten years deliver positive calendar year returns, which also means that two to three out of every ten years deliver negative calendar year returns. Also, on average, about 1 out of those 2-3 negative years every decade is a bear market, defined as a drop of 20% or more in value.
The most important thing to keep in mind is that the 10% average return that stock investors enjoy includes every correction and every bear market we have ever had, every one over the past 100 years! You don’t have to avoid them to achieve this return. You just have to make sure (if you are in the stage where you are living off of your portfolio) that you have enough of your portfolio not in stocks to be able to draw upon while the market is falling so you don’t have to sell stocks when everyone else is selling. The average bear market lasts about 18 months and the average increase in the 2 years following the end of the bear market is approximately 60%. So, on average, an investor that’s drawing on their portfolio would need about 18 months of cash flow from their portfolio derived from something other than stocks. Another key point investors presently need to remember is that market corrections, even in positive years, average about 12% per year. A 12% decline at some point during each year is average, sometimes more, sometimes less. In 2017, the biggest intra-year decline from peak to trough was less than 3%. This was not normal volatility.
Can’t I sell when the market starts to fall, avoid some of the losses, and then get back in later when it all seems clear?
Human behaviors’ basic desire to avoid loss makes this one seem like it makes all of the sense in the world. The problem is it is dead wrong. It is probably the single biggest contributor to investors’ failure to achieve returns anywhere near what the market returns in the same period. The reason is simple: it involves market timing, which no investor, institutional or otherwise, has been able to consistently get right. Many investors sell once they see the market start to correct but where they invariably fail is almost always staying out of the market too long. Timing requires guessing right twice, first you have to guess when the market is going to fall (or continue to fall) and then you have to guess when the market is done falling. There are so many factors that affect the stock market, and the direction of the stock market in the short run, that it is almost impossible to accurately predict its next move, let alone predict accurately twice in a row. If you don’t predict accurately, your return could be greatly affected. For example, if you were fully invested in the S&P 500 from 1994 to 2014, you would have received an annual return of 9.22%. However, if you traded out of the S&P 500 and this resulted in you missing just the ten best days during the same period, your annualized returns would have dropped all the way down to 5.49%. The good news is you don’t have to guess. All you have to do to be a successful stock investor, which we define as someone who receives market returns over time, is to diversify and not sell when the market is correcting or declining. Further, if you decide you want to reduce your overall equity exposure permanently, do it when the market is doing well, not when it is selling off.
Having a consistent investment in the stock market can make sense for many but it is important to remember that with it will always come volatility. Volatility is the price for higher returns.
Tom Reynolds, CPA & Matt Reynolds CPA, CFP®
Francis C. Thomas CPA, PFS
Robert T. Martin, CFA, CFP®
Gordon Shearer Jr., CFP®
Jeff Hilliard, CFP®, CRPC
(This article is for informational and educational purposes only and should not be relied upon as the basis for an investment decision. Consult your financial adviser, as well as your tax and/or legal advisers, regarding your personal circumstances before making investment decisions.)