Until quite recently, 2014 had been a very quiet and calm year for the stock market. With the exception of a few days in early February, the VIX had never spent any time above 20. As August ended, it stood at just under 12.
However, volatility has a nasty tendency to spike. And as AQR’s Cliff Asness explained, it can also be sticky: “When the market is volatile your best guess for next month is that it will be more volatile.” During September, the VIX began to creep up, ending the month at 16.3. Then, on Oct. 15, it spiked to above 31.
One thing I’ve learned over the years is that there’s a perfect correlation between a rising VIX and the volume of forecasts in the financial media predicting doom, as well as the number of calls and emails I receive from nervous investors and advisors.
Preparing For Volatility
With this in mind, I thought it worthwhile to discuss what you should do the next time there is an alarming spike in volatility.
The most important thing to understand is that both bear markets and volatility are inevitable. In fact, they are the true source of the equity risk premium, and why it has historically been so large.
Think of it this way: Stocks are riskier than bonds. Thus, investors demand a premium, in the form of a higher expected return, as compensation for taking the greater risk stocks entail. The key word is “expected.” If stocks always outperformed, there would be no risk in purchasing them. It’s the risk of the unexpected happening that leads to the equity risk premium.
The Importance Of Bear Markets
There’s another key point that warrants explanation. We’ve had three severe bear markets over the past 45 years: 1973-1974, 2000-2002 and most recently the one that began in late 2007. Remember, the equity risk premium is the compensation investors receive for bearing the risk of severe losses.
Now, imagine that instead of three bear markets that each saw market losses of about 50 percent or more, that the worst bear market over the past half-century had a loss of just 25 percent. If that were the case, investors might not consider stocks so risky. They wouldn’t require as large a risk premium because they’d be willing to pay higher prices, which is to say that valuations would be higher.
Thus, while it doesn’t feel like it at the time, severe bear markets are really a good thing—assuming you have the discipline to stay the course and not engage in panicked selling. If we didn’t have bear markets from time to time, valuations would be persistently higher. As a result, stock returns would have been persistently lower than they’ve actually been.
Discipline: The Key To Success
There are two keys to having discipline. The first is to accept the inevitability of bear markets as well as their unpredictability. In fact, about the only things we don’t know about bear markets are some of the most important—what will cause them; when they will occur; how deep they will be; and how long they will last. Since battles are won in their preparatory stages and not on the battlefield, to have financial discipline, you must accept these facts and build the inevitability of bear markets into your plan.
That means you cannot assume more risk than you have the ability, willingness or need to take. Otherwise, when a bear market does arrive, it’s likely your stomach will take over the decision-making. And I’ve yet to meet a stomach that makes good decisions.
The second key ingredient to success in staying disciplined is to understand that, since diversification is the only free lunch in investing, you should eat as much of it as possible. So how should investors think about diversification?