How To Acclimate To The Cold Sting Of Market Volatility

This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

When you jump into a cold lake, the change in temperature can be a shock, but as you get used to it, the temperature starts to feel less drastic.

That’s a bit like market volatility. 

Over the last three years, we got comfortable in the warm, welcoming lake of positive returns and low volatility in U.S. markets during 2016, 2017 and early 2018.

Then Q4 hit, and if you were (or are) feeling like you suddenly got dropped into a tank of ice water, you’re not alone. 

But when you take the long view—and if you’re a long-term investor, then you should—you’ll see that what feels jarring right now is actually just a return to normal levels of short-term volatility. A recent study from Guggenheim Funds showed that, since 1945, pullbacks (declines of 5% or more) happen about 1.5 times a year, and market corrections (declines of 10% or more) happen about once every-other-year. Further, they showed that the majority of declines fall within the 5-10% range with an average recovery time of approximately one month.

The upshot? Short-term declines are normal for a functioning market, and we should expect to see more of them in the future. Just as the initial shock of jumping in a cold lake passes over time, so too should the fear that sometimes comes with short-term market declines. 

So, what caused this bout of volatility?

We recently explored how U.S. market returns resembled a similar period in the late 1990’s when tech stocks traded to dizzying heights prior to the dot com bubble burst of the early 2000s. For example, if you look at the performance of the S&P 500 excluding tech stocks, the returns through Q3 were 7.86%, which is ok. However, when you add tech stocks back into the mix, you can see the role the tech sector played in setting record heights and levels of valuation because the return through Q3 jumps to 10.56%. 

While it’s true that the technology sector’s impact on market performance harkens back to the era, the most recent bout of volatility is being driven by more than high valuations. In Q4, as the market digests high valuations in the technology sector, it also needs to absorb rising uncertainty about future growth stemming from geopolitical risk and ambiguous economic data. 

The drivers of these uncertainties included: 

  1. The transformation of the Eurozone and the rise in populism globally, which has layers yet to be revealed and resolved 
  2. Increasing concerns that the U.S.-China trade war may not shape up as expected, as the recent arrest of Huawei CFO Meng Wanzhou is further decreasing the likelihood that a permanent trade deal will be reached
  3. The 2-year Treasury yield slightly surpassing the 5-year Treasury yield, or “inverting” in market jargon. This situation is not a common experience and more importantly is often interpreted as a signal of a pending recession.  (It’s also important to note that a recession typically doesn’t arrive until months or years after yields invert, and it’s the relationship between the 2-year and the 10-year Treasury yields that market professionals are watching most closely. The spread between the 2-year and the 10-year has tightened, but it has not inverted as of mid-December.)

Fight the urge to flee

Extremely high valuations and uncertainty in both geopolitical and economic realms made for a shock to the system, and the markets responded. When volatility goes up, research suggests that most humans’ flight or fight response kicks in. A falling market elicits the same response our ancestors would have had upon seeing a sabre tooth at the entrance to their cave—they’d flee to safety as quickly as they could. If you find yourself having a similar reaction to choppy markets and are tempted to flee to the relative safety of cash, I suggest you reconsider.

Here’s why: Selling stocks in response to market volatility has been shown to reduce returns over time. Dalbar, a respected independent expert for rating business practices, customer performance, product quality and service produces an annual report on investor behavior, which has demonstrated that investors generally don’t do well when trying to time the market. In their report, Quantitative Analysis of Investor Behavior, Dalbar looked at equity fund investor’s ability to time the market by looking at the Guess Right Ratio. The ratio looks at equity fund net inflows/outflows compared to the next month’s performance. If a net inflow is followed by a market gain, or a net outflow is followed by a market decline, then investors “guessed right.” In 2017, the study showed that investors only guessed right in three out of 12 months, despite the low volatility and consistent upward trend through 2017.

It’s hard enough to decide when to get out, but you have to decide when to get back in, which data shows is even a harder call.

To put it in perspective: For investors with a reasonably long time horizon, are you more concerned about a short-term market decline or running out of money? If you’re having trouble deciding, I’ll give you a hint: One of those scenarios lasts forever.

If the chill is still too much…

Many of us will be getting our quarterly statements in the coming weeks. If you open your statement, see your balance and feel like you need to do something, here are some productive things you can do (or check in to see that your advisor is doing for you):

  1. Tax loss harvesting: It’s unfortunate that you might have losses this year, but the IRS allows you to take the losses and bank them against future gains.
  2. Rebalancing: A value strategy at its core, rebalancing allows you to get back to your target allocation by selling what’s done well and buying what’s cheap.
  3. Educate yourself: Read about what’s going on in the markets and seek a better understanding of why you hold what you hold in your portfolio. If you understand the underlying basis for the decisions you and/or your advisor have made, it will put you in a much better position to make rational decision.

My favorite quote about investing came from Warren Buffett during the Great Recession. To paraphrase, he said, I am not sure what stocks will do tomorrow, next year or even five years, but 10 to 20 years from now I have a high level of certainty that stocks will be higher. 

I agree. There may be some shocks along the way, but that’s part of the risk that’s inherent in investing. Hang in there, because over time those that stay the course get rewarded. You don’t want to be left out in the cold.

Click here to see the article on Forbes.

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