After a period of relative calm in the markets, in recent days the increase in volatility in the stock market has resulted in renewed anxiety for many investors.
From February 1st to 5th 2018, the US market (as measured by the Russell 3000 Index) fell almost 6%, resulting in many investors wondering what the future holds and if they should make changes to their portfolios.[1] Subsequent equity market gains from Feb 12th to Feb 23rd eased investors’ fears a little, only to be stoked again by the most recent Trump administration announcement of tariffs on foreign steel and aluminum imports to the USA, stoking fears of the beginning of a global trade war. While it may be difficult to remain calm during a substantial market decline, it is important to remember that volatility is a very normal part of investing. Additionally, for long-term investors, reacting emotionally to volatile markets is generally more detrimental to portfolio performance than the market drawdown itself.
INTRA-YEAR DECLINES ARE COMMON
Exhibit 1 shows calendar year returns for the US stock market since 1979, as well as the largest intra-year declines that occurred during any given year. During this period, the average intra-year decline was about 14%. About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops, calendar year returns were positive in 32 years out of the 37 examined. This goes to show just how common intra-year market declines really are and how difficult it is to say whether a large intra-year decline will result in negative returns over the entire year.
Exhibit 1: US Market Intra-Year Gains and Declines vs. Calendar Year Returns, 1979–2017
In US dollars. US Market is measured by the Russell 3000 Index. Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.
INVESTOR REACTION IMPACTS PERFORMANCE DETRIMENTALLY
If one was to try and time the market in order to avoid the potential losses associated with periods of increased volatility, would this help or hinder long-term performance? According to the Efficient Market Hypothesis (EMH) for which Professor Eugene Fama received the Nobel Prize for Economics in 2013, current market prices aggregate all information and all expectations of market participant. As a direct corollary it follows that stock mispricing cannot be systematically exploited through market timing. In other words, it is unlikely that investors can successfully time the market, and if they do manage it, it is the result of luck rather than skill. Further complicating the prospect of market timing being additive to portfolio performance is the fact that a substantial proportion of the total return of stocks over long periods comes from just a handful of days. In fact, if you had missed the best 40 days of the past 5,037 trading days in the 20 year period from 1994 to end of 2013, your investment return for this whole 20 year period would have been negative, instead of a compounded average annual growth rate of 9.22% per year. To put it differently, if you just missed 0.8% of the best days during this period, you will have lost all upside of your investment strategy. Since investors are unlikely to be able to identify in advance which days will have strong returns and which will not, the prudent course is to remain invested during periods of volatility rather than jump in and out of stocks. Otherwise, an investor runs the risk of being on the sidelines on days when returns happen to be strongly positive.
Exhibit 2 helps illustrate this point for the most recent 27 years. It shows the annualized compound return of the S&P 500 Index going back to 1990 and illustrates the impact of missing out on just a few days of strong returns. The bars represent the hypothetical growth of $1,000 over the period and show what happened if you missed the best single day during the period and what happened if you missed a handful of the best single days. The data shows that being on the sidelines for only a few of the best single days in the market would have resulted in substantially lower returns than the total period had to offer. In fact, for this time period, the same picture emerges: if you miss only the top 0.9% of all trading days, your investments over these 27 years would have turned negative (instead of having grown from $1,000 to $13,739, i.e. an annualized 10.19% growth rate over 27 years).
Exhibit 2: Performance of the S&P 500 Index, 1990–2017
In US dollars. For illustrative purposes. The missed best day(s) examples assume that the hypothetical portfolio fully divested its holdings at the end of the day before the missed best day(s), held cash for the missed best day(s), and reinvested the entire portfolio in the S&P 500 at the end of the missed best day(s). Annualized returns for the missed best day(s) were calculated by substituting actual returns for the missed best day(s) with zero. S&P data © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. One-Month US T- Bills is the IA SBBI US 30 Day TBill TR USD, provided by Ibbotson Associates via Morningstar Direct. Data is calculated off rounded daily index values.
CONCLUSION
While market volatility can be nerve-racking for investors, reacting emotionally and changing long-term investment strategies in response to short-term declines will prove more harmful than helpful. By adhering to a well-thought-out investment plan, ideally agreed upon in advance of periods of volatility, and by staying within your own risk profile, investors will be better able to remain calm during periods of short-term uncertainty.
Footnotes:
[1]. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.
Sources: - Dimensional Fund Advisors - Morningstar - Ibbotson Associates - Yahoo Finance - Google Finance - CRSP - Frank Russell Company