Does Your Portfolio Embrace Market Volatility?
Many investors, who experienced the 2008 – 2011 stock market roller coaster ride, quickly developed a low tolerance for volatility. As a result they moved a significant portion of their investments into safer, fixed yield vehicles and many have yet to return to the stock market.1 What many investors may not realize is that wholesale switches from one asset class to another in order to avoid volatility can actually increase it. Secondly, for investors with a long-term perspective on their investments, volatility is actually a good thing, as it is the primary driver behind the sustained market gains over the last century.
Unquestionably the stock market has experienced some fairly severe volatility in recent years. But a more thorough review of the historical record provides a clearer perspective on market volatility over the decades that actually favor investors who manage to hang on even in the worst of market declines.
Winning with Market Volatility
Since World War II, the stock market has experienced, on average, an intra-year decline of 14 percent each and every year; and in that same period, the market ended lower, on average, by 18 percent every third year. Bear markets, with an average decline of nearly 30 percent, have occurred every fifth year. Yet, over that same span of nearly seven decades, stock market values have grown 100-fold, which means that, $1,000 invested in the stock market 70 years ago would have grown to $100,000 despite the periodic market declines. 2
The very profound and highly instructive take away from this is that market declines have, thus far, been nothing more than a momentary interruption in an enduring market advance. Hence, volatility is simply a necessary phenomenon of a market that works. On the other hand, market risk – the risk of incurring losses as stock prices fall – is human-induced. The only way investors actually lose money is when they sell their stocks.
Those who are suddenly spooked into bailing out of the market after it has already fallen 10 or 15 percent, will always lose money. Yet, history shows that the stock market rewards investors who can bear the volatility of stocks and avoid the harmful behavioral traps through various periods of performance. 3 So, the real risk to investors isn’t being in the next 20 percent market decline, its being out of the next 100 percent market increase.
Building Your Portfolio around Market Volatility
Proper diversification is the key to withstanding increased volatility and reducing downside exposure. A well-diversified, strategically allocated portfolio will almost always decline in value less than the stock market indexes. If your portfolio only declines 7 percent while the stock market declines 12 percent, you’ll have less to recover when the market rebounds.
Focus on your Long Term Objectives
During periods of increased market volatility it does little good to worry about the market-shifting macro events of the day that will have little or no impact on the long-term performance of your portfolio. The stock market decline of 2008 will turn out to be nothing but a small blip for a portfolio invested for 20 years. It took years for the investors who fled the market in 2008 to recoup their losses, while those who kept their sights on their objectives and stayed the course have enjoyed record gains in their portfolio.
Patience and Discipline
Volatile markets can cause investors to make costly mistakes, such as trying to time the market (which is very difficult at best), or chasing performance, or trying to pick the winners. These mistakes can cost investors a significant portion of their portfolio value. It takes patience and discipline to adhere to a strategy and avoid the herds. Stocks should be deliberately bought and sold according to a strategy, not in response to emotions.