Early Thanksgiving Gratitude List: Volatility
For investors accustomed to the relatively consistent upward march of the S&P 500 over the past few years, the recent equity market volatility has been a stark reminder that stocks don’t move in just one direction. When volatility materializes, it helps to put it in perspective and understand what, if anything, investors should do during periods of temporary market disruption.
Some Perspective
The stock market tends to go up more often than it goes down, particularly as you expand the time horizon. While this is a broad guideline to keep in mind, it’s also important to understand how normal market declines are. The market historically corrects (temporarily) by an average of nearly 15% per year, which makes the recent ~10% peak-to-trough decline look relatively unremarkable. Here is a chart that helps illustrate the historical behavior of the equity market (proxied by the S&P 500).
Bear Markets Are Common
Contrary to what the financial media would like you to believe, we know a decline of almost 15% per year is common. While you wouldn’t guess it based on market behavior in recent years, bear markets (defined as periods during which stock prices fall by more than 20%) are also a normal part of investing. The chart below provides a visual depiction of the bear markets in the S&P 500 since World War II. We included a handful of periods where the market declined by 19%, since such periods feel like bear markets.
On average, a bear market has occurred every five years or so, has lasted for longer than a year, and has witnessed a (temporary) peak-to-trough decline in equity prices of more than 30%. To put the ordinary nature of bear markets in perspective, based on history, the average investor can expect to experience eight bear markets during a 40-year working career and another six in a 30-year retirement.
The Benefit of Volatility
Although it can be difficult to watch your investment accounts shrink during market declines, volatility has a silver lining. The same volatility that gives investors ulcers helps explain why equities have historically provided a higher return than bonds. Investors require higher returns to own more volatile assets because such assets fluctuate more dramatically in price, which makes them more difficult to hold. This allows the patient and disciplined investor to earn a higher return simply by accepting the bumpier ride that accompanies investing in the stock market.
What Should Be Done in Response to Volatility?
A good financial plan should incorporate the inevitable volatility that accompanies investing in equities. Furthermore, a financial plan is driven by the goals and objectives of the individual, so unless those have changed, there is little reason to make changes in asset allocation or investment strategy in response to market volatility. In our next post, we’ll discuss some of the things that can be done to capitalize on market volatility, but suffice it to say that, from the perspective of overall investment strategy, the best advice is often “Don’t just do something, stand there.”
Conclusion
A bear market in U.S. stocks will inevitably arrive at some point (and will occur several more times throughout your life), and that’s okay. Volatility is an ever-present aspect of investing in stocks and every bear market historically has been a temporary interruption of a permanent uptrend. What matters is not the volatility itself, but how the investor reacts to the volatility. Periods of market disruption emphasize the importance of having a strong financial plan and a goals-based investment strategy, which provides an anchor to navigate inevitable market volatility. While every investor wants the premium returns of stocks with the low volatility of bonds, that’s like asking for dessert without the calories.
About MD Wealth Management: We are an Ann Arbor financial planner that specializes in providing financial planning for physicians and retirees. We are CERTIFIED FINANCIAL PLANNER™ professionals and fiduciary financial advisors who operate on a fee-only basis, which means we do not sell financial products or collect commissions. As an Ann Arbor financial advisor, we enjoy working with clients both locally and remotely.