Market Volatility and Investment Challenges

When is it easy to earn market returns?

This is a trick question, because the answer is, “Never.”

This is in part because volatility – the up and down movement stock markets experience – is more often distracting than it is cause for changing your investment strategy.

The market’s volatile range of returns in any given year has a way of conspiring to cause investors to change their portfolios at exactly the wrong times, chasing hot trends and fleeing the downturns. After the dust has settled, those who try to predict the manic market movements are often lucky to break even, let alone achieve the average return that would have been theirs had they patiently waited out the volatility.

Seeing Is Believing: Putting Volatility Into Perspective

Volatility becomes easier to manage with experience, planning and perspective. The following charts are designed to put stock market volatility into perspective.

Figure 1: Volatility Is the Norm

First, let’s share some numbers on how routinely we experience what seems like “excessive” volatility. This first graph displays returns of the S&P 500 Index since 1926. The blue bars show the return for the entire calendar year. The black and red lines show the largest daily gain and decline within each year.

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A key message here is that a lot of downside volatility has long been the norm (the red lines), even when returns more often than not ended on a positive note (the blue bars). A long-term focus can help block out the noise associated with short-term market volatility.

Figure 2: Earning the Average Rate of Return in any Single Year Is Unusual

The average return of the market is not the return earned each and every year. This may seem obvious but it is often overlooked in the throes of such frequent and significant volatility. Some year’s returns are higher than average some are lower.

The next chart documents the US market (equity) premium and shows periods in history when US stocks underperformed US Treasury Bills, or T-bills. (T-bills are considered a risk-free investment compared to stocks. Their returns exhibit very low volatility from one year to the next. They also are expected to deliver substantially lower returns over time.)

The yearly premiums (the bars) represent the return of the stock market minus the return of T-bills.

  • The blue bars indicate years when the broad US market delivered an average return above T-bills (positive equity premium).
  • The red bars indicate years when the market underperformed T-bills.
  • The dark blue bars indicate the years when a positive equity premium was within a 2% range of its long-term average, as indicated by the horizontal line.

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Here, we can see that the annual US market premiums have varied widely, routinely experiencing wide positive or negative performance swings relative to T-bills. Also, annual premiums have been close to their annual average (+/- 2 percent) only five times since 1928. This means that it takes patience and discipline to earn the average market return.

It’s also worth noting that the returns of the market versus T-bills have been positive considerably more often than they have been negative. On average, the annual market premium has experienced a stronger upside than downside – at least for those who didn’t succumb to trying to time the market’s returns.

The most important message here is that you have to expect to withstand a lot of volatility to earn the market’s average return.

Figure 3: The Passage of Time Helps

This graph compares five-year annualized performance of the US stock market vs. T-bills. The blue bars denote the five-year periods in which stocks beat T-bills; the red bars indicate when stocks underperformed T-bills.

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This graph clearly illustrates that US stocks outperformed T-bills in most five-year periods since 1928. But it’s also worth noting that there are fewer red bars in this graph (where each bar equals five years), than in the previous graph, where each bar is one year. It shows that time is typically our friend when it comes to investing.

To further ease the pain inflicted by potentially long periods of underperformance in any given corner of the market (i.e. for those times when the red bars dominate), it’s also wise to globally diversify your stock portfolio across multiple asset classes and to temper it with an appropriate measure of fixed income. Longer time horizons and effective diversification may still not make investing easy, but they at least make it less difficult. For more on the topic of volatility and other important investment considerations. Please visit out Evidence-Based Investing Website. There you will find materials designed to help you manage every market environment. In addition, please feel free to email me with any questions.

About Chas Boinske

Charles P. Boinske, CFA, is a 30 year investment management veteran overseeing the strategic direction and portfolio management process for Independence Advisors, LLC. Have a question for Charles? CLICK HERE TO ASK CHARLES

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