I came down with the flu this week. It started on Monday with some tightness in my chest, and has progressed to fever, chills, cough, aches, and extreme fatigue. It has been a long time since I have been sick like this. I had forgotten how miserable this can be, and honestly didn’t take it as seriously as I should have when my wife recently suggested I get a flu shot. I’m now paying the price for complacency.
After a period of relative calm in the markets, perhaps investors got a little complacent too. While the increase in volatility in the stock market has resulted in renewed anxiety for many, it can be helpful to remember that no matter how uncomfortable a selloff can feel, like the flu, it will eventually pass.
Since its peak on January 26th, the US market (as measured by the Russell 3000 Index) fell over 9%, resulting in many investors wondering what the future holds and if they should make changes to their portfolios. While it may be difficult to remain calm during a substantial market decline, it is important to remember that volatility is a normal part of investing. Additionally, for long-term investors, reacting emotionally to volatile markets may be more detrimental to portfolio performance than the drawdown itself.
Exhibit 1 shows calendar year returns for the US stock market since 1979, as well as the largest intra-year declines that occurred during a given year. During this period, the average intra-year decline was about 14%. About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops, calendar year returns were positive in 32 years out of the 37 examined. This goes to show just how common market declines are and how difficult it is to say whether a large intra-year decline will result in negative returns over the entire year.
Exhibit 1. US Market Intra-Year Gains and Declines vs. Calendar Year Returns, 1979–2017
Reacting Impacts Performance
If one was to try and time the market in order to avoid the potential losses associated with periods of increased volatility, would this help or hinder long-term performance? If current market prices aggregate the information and expectations of market participants, stock mispricing cannot be systematically exploited through market timing. In other words, it is unlikely that investors can successfully time the market, and if they do manage it, it may be a result of luck rather than skill. Further complicating the prospect of market timing being additive to portfolio performance is the fact that a substantial proportion of the total return of stocks over long periods comes from just a handful of days. Since investors are unlikely to be able to identify in advance which days will have strong returns and which will not, the prudent course is likely to remain invested during periods of volatility rather than jump in and out of stocks. Otherwise, an investor runs the risk of being on the sidelines on days when returns happen to be strongly positive.
Exhibit 2 helps illustrate this point. It shows the annualized compound return of the S&P 500 Index going back to 1990 and illustrates the impact of missing out on just a few days of strong returns. The bars represent the hypothetical growth of $1,000 over the period and show what happened if you missed the best single day during the period and what happened if you missed a handful of the best single days. The data shows that being on the sidelines for only a few of the best single days in the market would have resulted in substantially lower returns than the total period had to offer.
Exhibit 1. Performance of the S&P 500 Index, 1990–2017
While market volatility can be nerve-racking for investors, reacting emotionally and changing long-term investment strategies in response to short-term declines could prove more harmful than helpful. By adhering to a well-thought-out investment plan, ideally agreed upon in advance of periods of volatility, investors may be better able to remain calm during periods of short-term uncertainty.
Periods such as this provides us an opportunity to revisit our goals and tolerance for risks, as well as rebalance accounts that have drifted off target. If you need to discuss your portfolio, get in touch for a free review, but it may be awhile before I bounce back to form. For that matter, the same could be said for the stock market.
(Portions adapted from DFA’s February 2018 Issue Brief)
. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.
Source: Dimensional Fund Advisors LP.
Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.
There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.