Last week at my Rotary Club meeting, our scheduled speaker was a no show. When our President asked if anyone had something they would like to talk about, I offered to present one of my recent Accountable Update articles, 10 Questions for Every Investor.
The article was well suited for an impromptu presentation, with several charts interspersed with practical advice. But when we got to the Q&A, it became apparent that the recent market volatility was weighing on some folks. The question that was seemingly on everyone’s mind was, “When will stocks stop going down?”
My answer, as it is anytime someone asks me what I think the stock market will do tomorrow, is to offer a couple of tips for dealing with market volatility.
Tip #1 - Yesterday’s results do little to predict what will happen today.
First, there is no question that when stocks go down, investors’ anxiety level tends to rise. While it may be easier said than done to remain calm during a stock market selloff, it is important to remember that short-term results are inherently unpredictable. It is a common investment mistake to believe that recent performance somehow predicts what will happen next, but that is no more true in the markets than it is when you flip a coin. Even if you flip 10 consecutive heads, the next flip still has just a 50% probability of coming up tails, no more or less.
When it comes to stocks, in the last 40 years, every year experienced a stock market decline at some point during the year. The average of the largest selloff in each of those years was about 14%. About half of the time the declines were more than 10% and in a third of those years, were greater than 15%. However, as you can see in Exhibit 1, calendar year returns were positive in 33 of the 40 years.
Exhibit 1. US Large Cap Market Intra-year Gains and Declines vs. Calendar Year Returns
Tip #2 - Short-term Decisions Can Be Detrimental to Your Long-term Goals
It is tempting to try and time the market in order to avoid potential losses. But how would you answer if we rephrase and ask, how would you feel about reducing the chances of reaching your goals by missing market gains?
If current market prices reflect all of the information and expectations of market participants, there can be no systematic way to exploit pricing “mistakes” through timing the market. If someone manages to get it right and time a buy or sell just before the market moves in their favor, it is much more likely to be the result of good luck rather than skill. Think about it, have you ever had anyone tell you they are a retired market timer?
Further complicating the prospects of market timing is the fact that a substantial amount of the total return of the stock market has historically occurred in just a handful of days. Investors that attempt to identify good times to enter and exit the market are running a significant risk of sitting on the sidelines when those relatively few days of strong returns occur, and that can have a very detrimental impact on progress towards your goals.
Exhibit 2 illustrates the point. It shows the annualized compound return of the S&P 500 Index since 1990 and the impact of missing out on just a few days of strong returns. The bars represent the hypothetical growth of $1000 over the period and show what happened if you missed one or more of the best performing days during the period. The data clearly shows that sitting on the sidelines for only a few of the best days in the market can result in substantially lower returns. Now imagine how much longer you may have to work or wait for that dream purchase because you missed just a few days in the market.
Exhibit 2. Reacting Can Hurt Performance
While a stock selloff can be nerve-racking for us all, reacting emotionally and changing long-term investment strategies in response to short-term events can wind up harming more than helping. By sticking to a well-thought-out investment plan that takes your goals, resources, fears, and preferences into consideration, you should be able to remain calm during inevitable periods of short-term uncertainty. If you need to review your plan, get in touch.