Swedroe: Riding Out The Volatility

Since the middle of August 2015, market volatility has escalated. As is usually the case when volatility spikes, global equity markets have experienced substantial losses. While there are no doubt a multitude of contributing factors (as discussed in my blog post on Aug. 26, 2015), some of the most obvious are the slowdown in the Chinese economy—the world’s second largest—and the sharp pullback in its stock market, along with the collapse of the prices of industrial- and energy-related commodities.

Given the current downturn and increase in stock market volatility, many investors are concerned and wondering whether now is the time to rethink their portfolios. While investors should always make sure their appetite for risk matches the risk embedded in their investment portfolios, market movements alone are not a good reason to alter investment plans.

Stock markets have always been, and will always be, risky. Their inherent riskiness is, in fact, the reason stocks have provided higher returns than safe bonds.

Putting Market Volatility In Context

While recent stock market volatility has been high, markets have experienced periods of higher volatility in the recent past. My colleague and co-author Jared Kizer put together some charts that show the historical evidence on volatility. Figure 1 below shows the historical values of the VIX Index, the market’s “fear gauge,” over periods going back to 2007.

Historically, the volatility of the stock market has averaged about 20 percent per year. More recently, the market’s expectation for volatility has exceeded 40 percent. So volatility has certainly increased beyond its more “normal” levels.

However, Figure 1 shows that market volatility was at similar (and in some cases higher) levels for virtually all of 2008 and 2009, and even as recently as mid-2011. In fact, while you cannot see it on this chart, the VIX exceeded 80 on both Oct. 27 and Nov. 20 of 2008.

While recent volatility is certainly discomforting, investors should be aware that markets have gone through similar, and even more extreme, episodes of volatility in the not-too-distant past.

Calendar Year Returns Are Deceiving

Another way to get a sense of the market’s historical risk is to look at the calendar-year returns of the S&P 500 Index, a gauge of the performance of larger-company U.S. stocks, relative to the largest drawdowns that occurred in each of those years. The “drawdown” is the largest peak-to-trough loss that occurred in each of those years.

The blue bars in Figure 2 show, as one might expect, that the S&P 500 has experienced positive returns in the vast majority of years. However, the orange bars show that in a large majority of those years, the market experienced significant losses at some point during that year.

For example, while in 1998 and 1999, the S&P 500 was up 28.6 and 21.0 percent, respectively, in those same years, the S&P 500 had intrayear losses of 19.3 and 12.1 percent. This shows that in virtually all years, the market has a substantial “correction,” even in some years where the market is up strongly.

Since investors experience the pain of losses over shorter periods, we can also examine risk over a monthly horizon. As Figure 3 shows, since 1950, the S&P 500 has had 558 months with intramonth losses exceeding 2 percent; 182 months with losses exceeding 5 percent; 31 months with losses exceeding 10 percent; and 8 months with losses exceeding 15 percent.

Can You Time Markets?

When market volatility increases, market-timing strategies become appealing. The basic idea is to avoid the downside risk of the market while capturing the upside returns. In practice, though, correctly sidestepping downside risk is very difficult to do, and often counterproductive to attempt.

Providing us with evidence that timing the market should be considered a strategy that is fraught with opportunity (opportunity to lose money, that is) is a study that appeared in the Spring/Summer 2009 issue of Vanguard Investment Perspectives.

Defining a bear market as a loss of at least 10 percent, the study covered the period 1970-2008, which included seven bear markets in the United States and six in Europe. Once adjusting for risk (exposure to different asset classes), Vanguard reached the conclusion that “whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection, and market-timing proves a difficult hurdle to overcome.”

They also confirmed that past success in overcoming this hurdle does not ensure future success. Vanguard was able to reach this conclusion despite the fact that the data was heavily biased in favor of active managers because it contained survivorship bias.

The only really surprising fact is that the myth about active managers outperforming in bear markets persists. Long ago, William Sharpe demonstrated that anyone who can do simple arithmetic can understand that, regardless of the asset class or whether there is a bull or bear market, in aggregate, active managers must underperform simply because they have greater costs.

Sticking With Your Plan

While it is perfectly reasonable to be concerned with recent market volatility, you’re best served by developing a well-thought-out investment plan that reflects your need, ability and willingness to take risk—and then sticking to it.

While this approach can be challenging to maintain during periods of high volatility, the evidence shows that it is the surest path to achieving your financial goals. It keeps investment costs and taxes low, while also making sure the portfolio is always positioned to capture the long-term rewards that markets tend to provide.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.