By Matt Stratman
The stock market is one of the greatest creators of wealth, enabling companies to access investor capital and allowing investors to share in the growth of the companies. Nevertheless, for many people, the gyrations and volatility of the market can be extremely unsettling. Market swings are normal but sometimes our emotions can get the better of us.
Volatility describes the natural ups and downs of the financial markets. When the volatility within our portfolio rises, staying invested and sticking with the plan can be difficult. It’s human nature to want to protect our money by selling investments that are losing value. However, by acting on these urges to sell and moving into cash, an investor is locking in a loss rather than giving their investments the time needed to recover. By understanding that volatility is a normal part of investing and aligning your portfolio with your individual time-horizon and goals, you have a much greater likelihood of long-term success.
Volatility is Normal
Volatile stock prices, bear markets, and recessions do not mean the market is broken. Declines should be expected every now and then. According to the Capital Group, one of the world’s largest financial services institutions, between 1949 and 2018, on average the stock market declined by 5% three times per year, 10% once per year, and 20% once every seven years.
While no one likes experiencing a market decline, the risk you accept for investing in stocks is the very reason you should earn a higher return over a longer period. This is known as a risk premium. Simply put, you get rewarded with a higher return for taking the risk of investing in an uncertain asset.
When investing in the stock market, you are investing in companies that generate earnings. By investing in a broad selection of stocks, you are essentially betting on the growth of the economy. Both the U.S. and global economy have grown significantly over the past century and there is every reason to assume they will continue growing. Our population is growing, technology is advancing, the world is becoming more connected, and the standard of living continues to improve.
Even though the economy is generally growing, from time to time there will be shocks to the market causing volatility. Typically, recessions are caused by imbalances in the market which build up and eventually correct. Occasionally recessions are caused by “black swan events” which are rare and surprising events that have a severe impact on the economy. The coronavirus is an example of a black swan event.
The good news is that recessions tend to be much shorter and smaller in magnitude than expansions. Over the past 10 economic cycles, the average recession has lasted eleven months while the expansions have averaged 69 months. Because the stock market is forward-looking, it tends to decline prior to the recession and bottom out before the economy is fully recovered.
Stop Trying to Time the Market
Every year for the past 25 years, Dalbar, Inc. has researched and compared investor returns to the overall stock market returns. What they’ve found is that the average investor will often underperform the market by several percentage points. In 2018 the average investor underperformed the S&P 500 by 5.04%.
Emotional reactions to the market are the main driver cited for poor investor returns. Investors' behavior towards bull markets and bear markets can be equally detrimental. The fear of missing out when the market is rising often causes investors to purchase what is already highly priced. Likewise, loss aversion has caused investors to sell when the market has already sold off a large percentage of its overall loss.
Peter Lynch, one of the most successful investors in history, once said, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.”
The worst days in the market are just as difficult to identify ahead of time as the best days. It would be nearly impossible to exit the market prior to a major decline and know the exact moment when it is going to start going back up again. Sharp declines are usually followed by sharp positive rebounds. Shifting into cash during a sell-off can backfire because it is unlikely you will jump back in at exactly the right time. Many investors who do move to cash during volatile periods wait too long to get back in and miss much of the recovery.
Create a Plan and Stick with It
Having a thoughtful investment plan will help you stay focused on the target and provide a reason for investing through the ups and downs. Financial planning can include retirement and estate planning, gifting, and protecting against many of life’s uncertainties. This process involves budgeting, forecasting future expenses, setting an obtainable target, and designing the strategy to achieve your goals. Periodically it makes sense to analyze your progress and assess if the plan or strategy needs to be modified.
Don’t let a down market cause you to hit pause on your investment strategy. Rather than timing the market, invest a fixed dollar amount on a regular basis. By doing this you will ensure that you continue with your plan no matter what direction the market is moving. This strategy is known as dollar-cost averaging and when employees contribute to their 401(k) through regular paycheck deductions, they are dollar-cost averaging. By consistently investing a small percentage of each paycheck a retirement account can eventually grow to a substantial amount. By implementing this simple approach to investing you’ll get a better average cost over time. As the saying goes, “It’s time in the market, not timing the market.”
Deciding to invest through the ups and downs will reward the patient investor. When the stock market is declining, and volatility is increasing it can be helpful to view bear markets as an opportunity to buy-in when the market is on sale. When valuations are already high, future returns tend to be lower. During a volatile declining market you will be buying in at a lower price relative to earnings and the long term expected return will be higher.
Take the Right Amount of Risk for You
There are quantifiable ways to measure the risk within a portfolio and you shouldn’t take more risk than you are comfortable with. An investor’s time frame, such as retirement, will often determine the level of risk that is appropriate.
Someone younger in their career will have a longer time frame to comfortably withstand volatile markets. As this window shortens, many investors would choose to reduce the risk within their portfolio so a major bear market doesn’t derail their retirement timeline. Whether you are an aggressive investor who is striving for growth or a more conservative investor who is focused on principle protection you should make sure your portfolio is aligned with your comfort level. While it’s great when your portfolio is rising, if you find yourself losing sleep at night because your portfolio is losing too much during a market decline you may be invested too aggressively for your comfort level.
Diversification is essential for reducing risk within a portfolio. Having a concentrated position in an individual stock can be far riskier than a portfolio composed of multiple stocks and bonds. Any individual stock can have poor performance even in the best of times.
By allocating into a broad portfolio you will get the average of many stocks rather than placing a bet on a single company. This can be accomplished through purchasing index funds and mutual funds that invest in multiple stocks and bonds within an industry or asset class. A well-diversified portfolio will have exposure to domestic as well as international companies, companies of different sizes, and companies from different sectors of the market.
Bonds are also an asset class that can reduce the risk in a portfolio and provide income for investors. For conservative investors, there are even investments like index annuities that offer absolute downside protection and an interest rate that is tied to a market index. By giving up some of the upside potential you can rest assured that your investment won’t lose any of its original principal.
Over time, increases and decreases will cause certain investments within your portfolio to grow and others to shrink beyond an optimum level. During a bull market stocks will typically rise quicker than bonds, increasing your potential risk and setting you up for a larger loss when a bear market begins. The same concept holds true when the stock market is declining. If stocks have sold off significantly, you may find that bonds are now overweight within your portfolio and you would want to sell bonds and reinvest into stocks. Many investors may find it difficult selling the “winners” and reinvesting into the “losers.” However, by periodically rebalancing and maintaining your ideal allocation you are keeping your portfolio aligned with your true comfort level and risk profile.
Ultimately, it’s most important to have a vision for your future and a plan on how you’re going to get there. Markets will continue moving up and down with occasional periods of volatility. Determining the exact start date of a recession is impossible but it also isn’t that critical. By creating a portfolio properly designed for your time frame and objectives, not overreacting, and sticking to the plan, you will have a much higher likelihood of achieving your goals.
About the author: Matt Stratman is a financial adviser at Western International Securities. He focuses on helping business owners and entrepreneurs who are planning for retirement. With a strong client-centered approach, he creates personalized investment strategies to help them reach their financial goals.