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How to Handle Volatility

Markets have gotten much more volatile recently. Here’s why investors should keep their focus on the long game.

It’s been just over eleven years since the stock market bottomed at the end of the financial crisis. Investors who had grown accustomed to steady growth in their portfolios since then, who’ve seen only occasional corrections that amounted to temporary setbacks, might be getting nervous about now. Fears that the coronavirus will trigger a global recession that policy makers won’t be able to rein in have sent stocks into bear market territory for the first time since then. 

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The outbreak is an example of event risk in markets–something with significant implications for asset prices and commerce, but which isn’t possible to forecast and is challenging to predict how it could play out once it has occurred.  Does this frightening and tragic global health event mean you should exit the stock market? In short, no.

Volatility fluctuates based on where we are in the business cycle and external events that heighten risk and threaten growth, but this feature of markets is an unfortunately normal one that investors should expect.

Right now, we are in the midst of a major market drawdown that has begun to discount the end of over a decade of expansion that followed the financial crisis of 2008. The relative calm that markets enjoyed for years was brought about by a gradually improving global economy, low interest rates and global central banks that aggressively pursued unconventional monetary policies, like quantitative easing.

As generally happens when the cycle matures, central banks started withdrawing monetary stimulus in 2018. At that point, financial conditions tightened and global growth began to slow, which, together with worsening trade tensions, led to a market correction  significant enough to send stocks down for the year, albeit mildly. The course correction by policy makers in 2019 meant the poor returns did not last long as renewed stimulus and diminishing trade tensions sent stocks soaring to new heights in 2019, with the S&P 500 up over 30%.  

The pattern is a familiar one late in business cycles, as market downdrafts caused by economic concerns are followed shortly after by policy decisions that ignite rallies that take the market to new highs. However, at some point along the way we knew that the market’s headline-grabbing down days wouldn’t be so closely followed by a rally, and returns would head lower in ways that leave investors with material losses. That is the typical way the market responds to economic recessions, which it now appears almost certain we will face soon, due to the massive dislocations in commerce and credit created by efforts to control the outbreak and knock-on effects in the commodities markets and elsewhere in the financial system. While the virus is new, recessions are a feature of market economies as inevitable as the turning of the seasons. 

Common Investing Mistakes

Does that mean you should sell now?  Not necessarily. It’s extremely difficult to predict  market direction with the accuracy needed to profit from such a prediction. The experience of the sharp sell-off in 2018 followed quickly by the dramatic rally in 2019 was instructive in that regard.

More to the point, it is easy to get such a prediction wrong, which can be costly. While we do tilt our portfolios more aggressively or more conservatively based on our market outlook, the data shows that individual investors who radically reposition out of stocks in an attempt to catch the tip of a market top reliably miss out on gains more than they prevent losses, and generate excessive transactions and tax costs along the way.

While “buy low, sell high” may sound like time-honored advice, the challenge of getting it right means it rarely is a good way to make decisions in practice. Indeed, individual investors who stay in cash waiting for a bear market to come and go, often lose patience as stocks continue to go up. This results in their missing out on gains rather than preventing losses. That costly mistake is the reciprocal of another that is very common at times like this, wherein panicking investors sell during a major market sell-off, and remain on the sidelines too long as stocks rebound, effectively locking in their losses. The prevalence of these value destroying behaviors helps to explain why individual investors as a group tend to dramatically underperform market benchmarks.

There is a caveat to the generally superior buy-and-hold approach, which is that seeing a paper loss in your portfolio doesn’t feel good. Some investors would rather take less risk, which may mean giving up some long-term returns, in order to reduce the period of time they may need to wait out losses, making for smoother sailing. 

Consider Your Goals

Another factor to consider is how you’re doing relative to your financial goals. That’s where a Financial Advisor can help by talking through goals and priorities and reassessing your portfolio based on where you stand. For instance, if you are saving toward a goal and have made good progress, it may make sense to take on less risk, regardless of whether that decision will benefit your total returns. This is for two reasons. First, it intuitively makes sense to take less risk when you have more to lose than to gain. Second, for additional peace of mind that your progress won’t be jeopardized, you may desire the lesser uncertainty that can come from a more conservative blend of stocks, bonds and cash.

If, like many of us, you have more progress to make and more road to travel towards achieving your goals, riding out the market’s jitters can be the best advice. Our research shows that markets are most predictable when you have a seven- to 10-year time horizon (due to how well current yields and valuations predict returns over those horizons). Our forecasts continue to suggest that stocks will outperform bonds and cash over that time horizon.

Bottom line: Working with your Financial Advisor can help you avoid short-term thinking and remember that investing is a long-term proposition. Keeping your eye on the horizon is your best strategy as an investor.

 

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