Putting Volatility in Perspective

October 19, 2014 | by Justin Capetola

27 Years ago today…

You were probably grooving to the sweet sounds of Whitney Houston’s, I Wanna Dance with Somebody (Who Loves Me), while…
The market was crashing, struggling through the biggest single day decline in history also known as Black Monday. 

whitneyhouston

Putting Volatility in Perspective

On this date in 1987, the S&P 500 fell 20.5%.  This day still stands as the single worst day for the stock market on record, known as Black Monday.  While days like this have occurred throughout history, they are exceedingly rare.

Volatility, much like death and taxes, is an inevitable aspect of investing.  There are a number of ways to measure market volatility, with the VIX Index probably being the most common measure for investors. However, as an investor, the best measure of volatility may be your maximum drawdown (high to low point during the year). These drawdowns can range from a few days to a few months. Having the strength to stay invested during volatile times requires discipline that is always rewarded.

As an example, during 2012, the S&P500 had a 10% decline from April to June and another 7.7% decline from mid-September to mid-November.  There was certainly a lot of volatility experienced by investors during these times. Those investors who remained invested saw the S&P500 advance 13.40% for the year in 2012.

Although volatility is unavoidable, it should be a goal for investors to maintain a long-term investment view rather than finding reasons for short-term pessimism.  There will always be a reason to sell: negative economic numbers, wars, and the current Ebola virus outbreak, etc.

Warren Buffett once said:

“In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.” 

Ibbotson SBBI 1926-2010
(Click image to enlarge)

As an investor, your sensitivity to market volatility is mainly determined by your investment time horizon. As the example above proves, the S&P500 index rewarded those who stayed invested over longer time periods.  Broad market returns behave differently over daily, monthly and annual periods. 

According to Fidelity Investments, the median historical return is -52bps on down days and +51bps on up days for S&P500 daily returns.  To say another way, the daily S&P500 returns and volatility are unbalanced where negative days are worse than positive days are good. However, there a far greater number of up days than down days. In the 2012 example from above, the S&P500 moved slowly upward from the bottom of the 10% correction in June until reaching a high in mid-September.  All too often, it is easier for investors to sell first and ask questions afterwards.

Adding stability to the volatile markets

Stock market volatility can be mitigated by maintaining a long-term investment horizon and understanding markets risks.  During the 2008-2009 period in the stock market, traditional asset allocations were not as effective as everyone thought.  Many ‘uncorrelated’ asset classes exhibited similarity in market moves.  Utilizing a risk-based approach that incorporated short-term hedging (offsetting market risk) proved to be a great tool for combating market volatility and ultimately led to investors remaining invested.  It gave them the fortitude to remain invested and they were ultimately rewarded with the subsequent rebound in the markets. 

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