Volatility is driven by emotions, primarily fear and greed, and rarely do changes in fundamentals impact prices in a single day or week. Instead, relevant trends develop over time so the constant movements of prices in a portfolio on a daily basis tell an investor next to nothing about the actual risk in his/her portfolio.
Since volatility is nothing more than a measure of emotion, volatility spikes are actually nothing more than emotional spikes. Investors must do their best to avoid the “emotional traps” that come with these spikes, which is admittedly much easier said than done when it’s your retirement on the line.
Arguably the most dangerous of these emotional traps is panic selling, because it’s the worst possible outcome for the investor. Not only were they forced to endure the pain of sleepless nights while watching their portfolio get whipsawed, they then make the damage permanent by locking in a loss.
The most effective strategy to avoid emotional traps is to try to eliminate as much emotion from the investment process as possible. First, we need to become comfortable with the concept of volatility, what it really represents, and accept the fact that it very rarely causes a market to crash.
The information below tells of the number of big dips in the S&P 500 since 1950, along with the average size of the drop and frequency of big dips (aka “crashes”).
Average Dip -21.6%
Median Dip -16.5%
Average Length 7.8 Months
Greater Than 20% Dip 9 Times
Greater Than 30% Dip 5 Times
These numbers may appear frightening upon first glance, but let’s consider the following three key conclusions:
The S&P 500 has experienced 28 dips greater than 10% since 1950, which equates to an average of one every 20 months. However, half occurred in the1970s and 2000s (both bear market decades), meaning corrections occur far less frequent when we are in a bull market decade. We actually saw just one correction in the 1990s (the last bull market decade).
The average recovery time from a correction was less than eight months. Paper losses rarely persist for more than a year and highlight the inherent dangers within panic selling.
The S&P 500 has only seen five drops greater than 30% in 65 years, or roughly once every 13 years. Furthermore, more than two-thirds of corrections fail to develop into a 20% or more loss.
The net result of our analysis is that investors lose money when they assume that the market is crashing every time it falls. The reality is that crashes are very rare, and when they do occur they usually persist for a short period of time.
Said another way, panic selling, not volatility is the reason why investors lose money when the market dips.
Luckily there is a very simple and easy approach to reducing the volatility in a portfolio. For example, if an investor were to have a 1-year holding period, then the largest return possible would have been 56.5%, and the largest loss would have been -45.2%. By extending a holding period to 5 years or longer, the dispersion falls, which leads us to three very important conclusions:
Notice how the maximum possible return is cut in half when an investor goes from a 1-year holding period to a 5-year, but more importantly, the minimum return is one-third of the 1-year holding period. Meaning, a longer holding period has a larger and more favorable impact to the loss potential to a portfolio.
The worst possible return that an investor could have realized in any 10-year holding period since 1926 was -1.6%. More encouraging, there has never been a 20-year holding period that has lost money in the S&P 500.
The green dot indicates the average annual return for each holding period, which is practically unchanged at 10% during each period. The long-term average for equities is not impacted by its holding period, so investors do not risk lower average returns by staying invested longer (a fancy way of saying that equities continue to rise over the long run).
The net result of these findings is that a longer holding period will dramatically reduce volatility in a portfolio without impacting the long-term average return. Therefore, the most effective strategy to reduce volatility in a portfolio without sacrificing returns is to ignore emotional traps and remain invested.
NOTE: These examples pertain to the broader market, but the conclusions can be applied to most equity strategies. Meaning, those investors that try to time mutual fund buys and sells are falling into the same emotional trap as those who try to time markets using index funds.
Memorize the following statement: “Volatility Does Not Measure Risk.”
Say it over and over again. Tell your loved ones. Tell your neighbors. Make this concept a way of life so when the next time we see a surge in volatility, you can remind yourself that volatility spikes are nothing more than emotional spikes.
An economy does not fall into a recession overnight, and a company does not lose their competitive positioning before noon on a random Tuesday (only to re-acquire it back by 9:30am the very next day). These emotional traps are an unfortunate reality in markets, so the best way to navigate them is to ignore them.
It’s also important to understand that there are times to sell equities and become defensive. However, I continue to believe that the risk of a U.S. recession is low, and U.S. equities remain fairly valued with very few signs of bubbles forming.
Therefore, until our economic environment changes, I welcome these volatility spikes because our investment strategy is predicated upon profiting from the fear and panic of others.
The bottom line is that the absolute best way to avoid falling into these emotional traps is to keep a long-term focus and ignore the daily swings in equities. Volatility and risk are two completely different concepts, and we urge investors to focus solely on managing the risk while ignoring the volatility.
We are an independent financial service firm helping individuals create retirement strategies using a variety of investment and insurance products to custom suit their needs and objectives. Financial planning, investment advice and insurance provided through Business-owner Strategies Group, LLC a North Carolina Registered Investment Adviser and Licensed Insurance Agency d/b/a BSG Advisers. Wealth CAPS does not provide legal or tax services.