Stock Market Volatility: An Unpleasant but Normal Part of Investing

Stock Market Volatility: An Unpleasant but Normal Part of Investing

As published in the Fall 2015 Edition of NJ Lifestyle

Arguably the most difficult aspect about investing in the stock market is the volatility that is the trade-off for higher long term returns. During the past 40 years, the S&P 500 (widely regarded as the standard index for measuring Large Cap U.S. stock market performance and includes the 500 largest U.S. Corporations by market capitalization) realized an average annual total return of 11.4%, according to S&P Dow Jones index data. However, to have benefited from such performance, an investor would have had to stay the course through periods of significant volatility. Market declines of 10% or greater (typically defined as Corrections) have happened more than 15 times over that forty year period, including four bear markets (defined as market declines of 20% or more). Corrections happen on average once out of every 18 months. Until the recent decline in August, the markets had been more than four years since our last 10% pullback. Corrections are normal and are to be expected when investing in equities. That doesn’t, however, mean they are not unpleasant and unnerving to most investors.

However, one of the most important jobs for a financial advisor is behavioral coaching. The Vanguard Group, often viewed as a haven by do-it-yourself investment folks, authored a white paper in March 2014 which indicated, based on their study that on average investors with a financial advisor did better than investors without an advisor by about 3% per year. They attributed 1⁄2 of this 3% or 1.5% to behavioral coaching, up to .75% to asset allocation and up to 0.70% to spending strategy (withdrawal order).

One of the most important coaching points an advisor communicates to his or her clients is to make sure clients don’t sell stocks when everyone else is selling. During most market pullbacks, there are more sellers than buyers, causing the price to fall. Clients who wish to reduce the volatility of their portfolios are encouraged to do so after a good year, not during a negative one. In the last 89 calendar years, stocks have had positive returns in 65 years and have been negative 24 years. That means 73% of the time, or 7 to 8 out of every ten years, tend to be positive. The markets have been negative in consecutive years only 4 out of those 89 years. This indicates that investors shouldn’t have to generally wait too long until stocks will be higher after a sell-off , and therefore, are almost always better waiting to reduce their equity exposure (if that is what they are looking to do) when the markets have stabilized.

The other important coaching point advisors must continuously stress to their clients is to avoid trying to time the market. Often investors think they can sell when markets start to decline and get back in when things improve. There are two problems with market timing. The first is you have to guess right twice. You have to know when the market is going to drop for some period of time and sell before that happens. Then, the harder part, you have to know when the market has bottomed and going back in. We have not seen anyone in practice that has been able to do this consistently. In fact, a 2015 report form Dalbar, a financial services consulting firm, found that investors who tried to time their market returns over a 30 year period underperformed the market by more than 7% per year on average (The S&P 500 returned an average of 11.2% over that 30 year period, while the investors they followed averaged just 3.8% per year over the same period). We believe this is clear evidence that investors who wish to invest in the stock market are better off investing for the long term (buy and hold) and controlling their volatility (risk) through their asset allocation (how much they have invested in stocks).

Authors:
Tom Reynolds, CPA & Matt Reynolds CPA, CFP® (Co-Managing Partners, CRA Financial) 
Francis C. Thomas CPA, PFS (Investment Advisor) Robert T. Martin, CFA, CFP® (Investment Advisor)

(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.)