The recent gyrations of the stock market may have some investors feeling queasy. After the pandemic-induced crash in 2020, investors may have less tolerance for volatility. But those who don’t think they can manage another roller coaster ride should think twice before jumping off now. First, investors who try to jump in and out of the market to avoid volatility actually create more of it in their investment portfolios. Secondly, if you have a long-term orientation for your investments, volatility is actually a good thing because it’s what creates returns. By trying to avoid it, you’ll miss out on the biggest returns in the market. We’ll explain.
What Exactly is Market Volatility?
First, it’s important to dispel misconceptions about market volatility. Many investors conflate market volatility with risk, but they are entirely different. Volatility is a measure of the degree to which stock prices fluctuate up and down. During periods of volatility, stock prices can swing unpredictably and sometimes wildly. During 2021, we saw very few periods of market volatility—it was mostly a smooth ride.
On the other hand, risk is the chance that stock prices will decline, creating the possibility you could lose money. It’s only a possibility because you can’t lose money if you don’t sell your investments. Some stocks are considered riskier than others because they tend to be more volatile. Investors will take on that higher risk in return for the possibility of higher returns. In that sense, risk and returns are very much related. But risk-tolerant investors also must be able to withstand the stock’s volatility.
What Does Extreme Market Volatility Mean?
Extreme market volatility can occur at any time due to many factors, including macro-economic events (rising inflation), changing government or tax policies, a banking crisis, investor attitudes about current market conditions, or even geopolitical events. If, for any reason, investors sense that the risk of holding stocks outweighs the potential upside, they will start to sell their stocks.
Generally, periods of high market volatility are associated with a declining market. Market selloffs can trigger an avalanche, sending stock prices down much faster than when they’re going up. So, periods of lower volatility tend to be associated with rising stock prices.
Why Volatility is not Necessarily a Bad Thing
Undoubtedly, we have seen some severe stock market volatility in recent years. But it’s essential to put that in perspective. Since 1980, the market has experienced an average intra-year decline of 14%. However, the market ended the year lower only 22% of the time during that same period.
Bear markets have occurred every fifth year, averaging less than 30 percent. But that hasn’t prevented the stock market from growing nearly 3000-fold since 1950. A $100 investment in the S&P 500 at the beginning of 1950 would have grown to nearly $272,500 at the beginning of 2022, assuming dividends are reinvested. That is an annual average return of 11.6% per year.
The critical takeaway is that market declines, regardless of how steep, have been no more than a temporary disruption of a more enduring market advance. In that regard, volatility acts as a sling to propel the markets higher.
History shows that the market rewards those who can withstand market volatility and avoid behavioral mistakes such as selling into a market decline. When the stock market turns volatile, the most significant risk to investors is not a declining market; but how they react to them. The instinct to abandon the market, triggered by the fear of losing money, can be overpowering. But the historical data shows those who try to avoid the worst days of the stock market invariably miss the very best days of the market. Thus, their investment performance suffers.
Consider this graphic from Fidelity Investments, which shows how your returns would have been impacted on a $10,000 investment if you missed the market’s 5, 10, 30, and 50 best days.
The hypothetical example assumes an investment that tracks the returns of a S&P 500® Index and includes dividend reinvestment but does not reflect the impact of taxes, which would lower these figures. “Best days” were determined by ranking the one-day total returns for the S&P Index within this time period and ranking them from highest to lowest. There is volatility in the market and a sale at any point in time could result in a gain or loss. Your own investment experience will differ, including the possibility of losing money. Source: Bloomberg, as of 3/31/2020.
For example, in 2020, there were two days that saw more than a 9% gain in the S&P 500. Both market bursts occurred during the steep, COVID-induced market downturn. The first 9%+ gain occurred on March 13, one day after the second-worst return day in two decades. The second 9%+ gain occurred the day after the market hit bottom on March 23. Both days were among the top ten return days in the market’s history.
In the months to follow, the market rebounded 40% from the March bottom. However, if you managed to miss the five best return days during that rebound, your portfolio would have lost nearly 30%–proof that time in the market, not market timing, is the key to positive long-term returns.
Learning to Embrace Market Volatility
Investors who are suddenly spooked into abandoning the market after it has already fallen 15 percent will permanently lose money. Getting that loss back can be challenging because when you decide to jump back in, you’ll need to generate a return of 30 percent to get back to where you were. It is better to ride out volatility and take advantage of the upward market bursts it can produce.
Here’s what you can do to better withstand a bout of severe volatility:
Make sure your investments are properly diversified: Optimally diversified portfolios tend to decline at a slower rate than the market indexes. The key is choosing investments with low correlation with one another and the stock market as a whole.
Stay laser-focused on your long-term objectives: When the market whipsaws around, there is no benefit in wringing your hands over something that will have little if any impact on the long-term performance of your investments. Stop paying attention to the media and your investment accounts and focus on your long-term investment strategy.
Learn patience and discipline: Investors make their most costly mistakes when the market turns volatile, such as selling into a steep decline or trying to time the market. Mistakes like these can cost you a significant portion of your portfolio value, which can be difficult to make up. Keep your emotions at bay and stick to your strategy. Since its inception, the stock market has always rewarded patience and discipline.
Ignore the media noise. As an investor, the media is not your friend. It doesn’t share your objectives or concerns. It is only out to make money, and it does that by selling advertising. Shock and awe headlines sell advertising, and good news doesn’t. That doesn’t mean you should ignore negative news. It’s good to be informed about events that could impact you. However, it’s vital to keep it in perspective, especially as it pertains to your investments. Market declines triggered by bad news are only temporary, reflected as a minor blip on your investment performance over the long term.
You can expect more market volatility in the months and years to come. It’s essential to remember that volatility and risk reflect a healthy stock market—it’s how the market works, and it’s what generates positive returns over the long run. The key is to have clearly defined objectives and a sound investment strategy to focus on and let the markets do the work for you.
Contact a Dechtman Wealth Management advisor today for a no-obligation portfolio review to help you determine if you’re well-positioned during this period of increasing volatility.
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