Investing with Composure

2022 has been a turbulent year across equity and fixed income markets, with diversification providing little relief. Fears of persistent inflation and an overly hawkish Fed have increased the risk of recession, while heightened geopolitical uncertainty has added yet another wrinkle to an already complex global backdrop. However, rather than running away from market volatility, investors should maintain composure and embrace it, as higher volatility has historically created significant long-term investment opportunities.

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1. Drawdowns can range from mild to severe

These drawdowns can occur over days, weeks or months. Having the fortitude to stay invested during these periods requires discipline that has often been rewarded. For example, the maximum drawdown of 5.8% in 2013 occurred when the Federal Reserve began hinting at reduced asset purchases. Despite the negative market reaction and subsequent volatility, these events had little effect on underlying economic growth trends.

Consequently, those who stayed invested benefited from the subsequent rebound. Not only did the market recover within two weeks, but the intra-year pullback also ranks as the ninth shallowest on record in the past 86 years.

2. Volatility is normal and should be expected

On October 19, 1987, later referred to as Black Monday, the S&P 500 experienced a fall of 20.5%. This is still the worst day for the stock market on record. While days like Black Monday have occurred throughout history, they are rare and unpredictable. In fact, because Black Monday was a result of trading behavior and not market or economic fundamentals, the S&P 500 still finished the year with a slight gain.

Volatility is unavoidable in investing. There are many measures of market volatility including the standard deviation of returns, the VIX index, implied options volatility and dozens more. For long-term investors, the most meaningful measure may be the largest intra-year decline (or maximum drawdown) since it represents the largest loss an investor experiences during a given year.

3. Moderate pullbacks happen frequently even in normal times

Market corrections of 20% or more have historically occurred at the end of market cycles. But how volatile can markets be in the short run? Historically, the market has pulled back 5% an average of 6 times a year. Drawdowns between 2% and 3% occur far more often, at least monthly on average, and have historically fully recovered within weeks.

Short-term pullbacks occur frequently and should not in and of themselves be reasons for panic. Instead, investors should focus on underlying market fundamentals and the economic outlook when deciding whether to adjust their long-term portfolio allocations.

4. The investment time horizon is a powerful tool for managing volatility

Although volatility is unavoidable, it is a reason for investors to maintain a long-term perspective rather than a reason for pessimism. After all, an investor’s sensitivity to market volatility is largely determined by their investment time horizon, and US equity markets have rewarded those who have stayed invested over longer periods of time.

Over any one-year period, the S&P 500 has experienced gains as high as 51% (in 1954) and losses as low as -37% (in 2008). Clearly, an undiversified equity portfolio is inappropriate for short-term goals.

Simply expanding to a five-year holding period improves the risk-return profile of stocks dramatically, with the worst five-year period since 1950 experiencing only a 2% decline. Most importantly, there has never been a twenty-year period in the post-war era that has experienced losses.

While this is no guarantee of future returns, it demonstrates the importance of specifying the right time horizon to minimize portfolio risk.

5. Longer time horizons can allow markets to work for investors

Time horizon matters.

The bars on the one-year chart show the values of successive $100 investments that were made one year earlier. The periods highlighted in grey represent periods when a loss would have been experienced at the end of each investment horizon. For a one-year horizon, these periods occur quite often, resulting in risk regardless of the market cycle. The initial $100 investment would have lost close to $50 in 2008 from the year prior, while investing near the bottom in 2009 would have resulted in a gain of over $50 a year later.

By contrast, there are fewer periods when a five-year portfolio is underwater, and the periods that do occur are related to broad market cycles. In other words, these periods are less idiosyncratic. This is why strategies that invest over a market cycle, such as dollar-cost averaging and dividend reinvestment, are powerful.

A 10-year window only performed poorly during the Great Depression and the Great Recession. Stock returns over 10-year holding periods beginning in 1936 to 2003, a 67-year stretch, were positive.

The returns generated are far larger over the longer horizon due to compounding. Investors who can see beyond short-term market volatility by expanding their time horizons can benefit from broad market and economic cycles.

6. Portfolio diversification and rebalancing can provide greater stability in volatile markets

Stock market volatility can be managed through diversification and rebalancing. Over the last 15 years, the asset allocation portfolio has generated an annualized return of 5.7%, comparing quite nicely to other major asset classes. More importantly, by diversifying and rebalancing, an asset allocation portfolio achieved these returns with lower volatility than other equity asset classes. Over this 15-year period, the asset allocation portfolio’s volatility was two-thirds that of the overall stock market and almost half that of emerging market equities.

7. The last 20 years have favored the diversified investor by controlling risk

Solid returns and lower volatility for the asset allocation portfolio result in a superior risk-return profile. The chart shows that the realized Sharpe ratio, which measures the trade-off between returns and volatility, is higher for the asset allocation portfolio than any other equity asset classes. The historical record shows that diversification and rebalancing are powerful tools for combating market volatility.

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