Warburton Capital Management
So, a buddy comes in. Our buddy is concerned about recent market volatility and is wondering if his portfolio needs to be ‘adjusted’.
Our buddy opened up with “The markets are crashing. Maybe I need to sit in cash and wait for the market to turn around?”As is the case with our buddy, the recent increase in volatility of global stock markets has resulted in investor High Anxiety! (Are you old enough to remember the 1978 Mel Brooks movie bearing this title? It wasn’t about stocks…but…anxiety is anxiety!)
As I compose this missive on Sunday, October 28th, the Russell 3000 is down by 1.06% YTD – not really a dramatic YTD outcome. More significantly, from its all-time intra-day high on September 20th thru October 26th, the US market (again, as measured by the Russell 3000 Index) fell 10.0%. Is this a dramatic decline? I view it as precisely a routine correction, however, I do realize that any correction is ‘less than ideal’ for investors that only expect the markets to go up!
Today, investors are wondering what the future holds and if they should make changes to their portfolios. While it may be difficult to remain calm during any market decline, it is important to remember that volatility is a normal part of investing – excepting in low returning instruments. It develops that, for long-term investors, reacting emotionally to volatile markets may be more detrimental to portfolio performance than any mark correction.
Let’s Explore Intra-Year Declines
Exhibit 1 on the following page shows calendar year returns for the US stock market since 1979 as well as the largest intra-year advances/declines that occurred during those years. During this period the average intra-year decline was about 14%. In about half of the 39 years observed we witnessed declines of more than 10%. About a third exhibited declines of more than 15%.
Curiously, despite substantial intra-year declines, calendar year returns were positive in 33 out of the 39 years examined. This illustrates how common market declines are and how difficult it is to say whether any intra-year decline will result in a negative return over the calendar year.
Exhibit 1: US Market Intra-year Gains and Declines vs. Calendar Year Returns
In US dollars. US Market is measured by the Russell 3000 Index. Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.
Let’s Explore How Reacting Can Impact Performance
If one were to try – and many do try – to ‘Time The Market’ in order to avoid the drawdowns associated with 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 to, that success 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 reveals 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 2: Performance of the S&P 500 Index
In US dollars. For illustrative purposes. The missed best day(s) examples assume that the hypothetical portfolio fully divested its holdings at the end of the day before the missed best day(s), held cash for the missed best day(s), and reinvested the entire portfolio in the S&P 500 at the end of the missed best day(s). Annualized returns for the missed best day(s) were calculated by substituting actual returns for the missed best day(s) with zero. S&P data © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. One-Month US T- Bills is the IA SBBI US 30 Day T-Bill TR USD, provided by Ibbotson Associates via Morningstar Direct. Data is calculated off rounded daily index values.
While market volatility can be nerve-racking for investors, reacting emotionally and changing long-term investment strategies in response to short-term market declines could prove more harmful than helpful. By adhering to a Purposeful Investment Plan – developed to achieve a particular investors goals and derived well in advance of periods of upward or downward volatility – investors may be better able to remain calm during periods of short-term uncertainty.
As regards my buddies’ concerns about “Markets Crashing”, we were able to talk him down off the ledge by pointing out that he had a sufficient amount of assets purposefully dedicated to short term investment-grade bonds such that his Spending Currency is assured for two decades. (Our buddy is comfortable with a twenty-year bet on the markets with a portion of his wealth.)
Trusting this missive will find you enjoying life (rather than stressing out over market volatility) and comforted knowing that you have a Purposeful Investment Plan in place to provide you with a couple of decades of Spending Currency in retirement.
Warburton Capital Management