For most investors, volatility in the stock market creates more fear than almost anything else. Bear markets (measured by the S&P 500 being down 20% or more) and smaller corrections (measured by the S&P 500 being down 10%) are enough to cause the common investor to start going through a number of emotions that may cause them to consider making irrational decisions like selling everything and going to cash. Another common mistake made out of fear is making changes to their asset allocation because of the market environment. This is because most of us have our hard-earned retirement savings invested in the stock market and do not want to watch our wealth evaporate so we think sitting on the sidelines and waiting for the volatility to subside is a good strategy. In reality, we need to start accepting volatility as the tool to get us to the long term expected returns that we expect.
It can be hard to battle the emotions because of loss aversion which is a cognitive bias that explains why individuals feel twice as much pain from a loss in a portfolio compared to the happiness they feel with the same amount of gain. As a result of this cognitive bias individual investors tend to try to avoid losses in whatever way possible. This is why staying invested during all of the chaos seems counterintuitive from what our emotions are telling us at that moment.
Sure, we all know that risk and return are related and that we have to take a certain amount of risk to generate a certain amount of return over the long-term, but the short-term volatility does not feel good along the way. What I want to do is create a new way for investors, like you, to look at volatility.
What if we all started looking at volatility in terms of a fee that you have to pay. Not necessarily a dollar amount you pay out of pocket, but the range of outcomes, either positive or negative, that your portfolio may have to go through in order to have a successful outcome. So, the more aggressive your portfolio is the higher fee you will have to pay in order to enjoy the higher expected long-term rates of return you would expect.
Volatility, when properly understood, simply refers to the random distribution of big ups and downs around a predictable upward sloping long-term trendline. We know that the S&P 500’s long-term average is right around 10%. One thing you may not know is that it has only been within two percentage points of that 10% six times in the past ninety-five years. Yearly returns have ranged as high as 54% and as low as -43% and everything in between to get the average return of 10%. Since 1926, annual returns have been positive 70 times and negative 25 times so the odds of having a positive result are in your favor.
Since we know that the market is up more often than it is down it statistically makes more sense to be invested throughout all market cycles because it is near impossible to consistently get in and out of the market at the correct time. If this is the case then why does the common investor, over time, get lower rates of return when they invest on their own rather than working with an advisor? The answer is quite simple and it’s that good investing isn’t about making great decisions, it is more about consistently not making the one or two big mistakes over a 30-year timeframe. In other words, the common investor or do it yourselfer, buys and sells at precisely the wrong time. Here is a famous sketch by Carl Richards of the New York Times which is a great example of what is happening when you start making investment decisions based on emotion rather than proven techniques that work over time:
To further confirm my logic let’s take a look at the picture below which is a graph of the S&P 500 that illustrates successful investing over a long period of time. From 1957 until 2017 the market went up about 10.23% if you include re-investing dividends. These results over a 50-year period are fantastic, and if we could get the same result over the next 50 years it would be incredible, but what kind of volatility did we have to go through over that timeframe?
Now let’s take a look at the same graph, but this time we will add in the volatility along the way. The yellow lines are when the market was down 5% from its all-time high. The orange is when it is down 10% from its all-time high. The blue is when the market was down 20% or more from its all-time high. So, you start with the picture of successful investing and then you layer on the volatility of what happened in between, and it is complete chaos. Another thing that this graph illustrates is how hard it actually is to market time. It is important to understand that we have investors all over the world who are saying “this doesn’t feel right, this feels wrong, this is broken, so I want out and so I’m going to sell.” The idea that something can do so well over time despite the incredible volatility and wild market swings is counterintuitive. If we can embrace that concept and accept that volatility is part of the process, then we can take advantage of the wonderful long-term results of the stock market.
Finally, some of the most important things we are able to take advantage of if we accept volatility as the fee to successful investing are rebalancing and tax loss harvesting. Rebalancing is the art of buying low and selling high which can take the emotion completely out of investing. If you would like to read more about rebalancing click to read our past blog post here. Another strategy we can use is tax loss harvesting which allows us to sell a losing security to realize losses and then simultaneously replace it with a very similar security which allows us to participate in the recovery of the market. Again, for more information about this strategy take a look at our blog post here.
When you piece everything together, it starts making a lot of sense to have a financial plan in place to help create peace around the issue of money. Our goal is for you to feel comfortable with the ups and downs of the market, even if it is uncomfortable in the short term. The great thing about the portfolio which is designed specifically for you is that we know the volatility is coming and we know that your portfolio is designed to weather through the storm, over the long-term, to help make your plan come to life.