3 Ways to stay composed during volatility - J.P. Morgan Asset Management

3 Ways to stay composed during volatility

Rather than fear volatile markets, investors should keep three principles in mind.

Volatility is unavoidable in investing. But overreacting to short-term news and normal market movements often leads investors to inappropriately alter their asset allocations, potentially harming their ability to achieve long-term investment goals. Rather than fear volatile markets, investors should maintain their composure by staying focused on long-term economic and market expectations, and keeping three simple principles in mind.

1. Put volatility in perspective

Market drawdowns can occur frequently—over days, weeks or months—but having the fortitude to stay invested during these periods requires discipline that has often been rewarded. Exhibit 1 from the Guide to the Markets shows the largest intra-year decline an investor experiences during a given year. Despite average intra-year drops of 14.2%, annual returns are positive in 27 of 35 years.

Exhibit 1

In fact, the market has pulled back 5% an average of four times a year, or about once a quarter. Despite this, the market has tended to fully recover within three months. Drawdowns between 2% and 3% occur far more often, at least monthly on average, and have historically fully recovered within weeks. Thus, 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.

2. Focus on longer investment time horizons

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 his or her investment time horizon, and U.S. equity markets have rewarded those who have stayed invested over longer periods of time. Broad market returns behave differently over daily, monthly and annual periods. Exhibit 2 from the Guide to the Markets demonstrates that expanding the investment holding period over years and decades has historically improved the risk/return profile of an investor’s portfolio. 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 important, there has never been a 20-year period in the postwar 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.

Exhibit 2

3. Diversify

Stock market volatility can be managed in a portfolio by following a disciplined diversification and rebalancing investment approach. Exhibit 3, also from the Guide to the Markets, illustrates the performance of a diversified portfolio relative to the performance of the underlying asset classes. Over the prior 15 years, the asset allocation portfolio has generated annualized returns of 5.3%, comparing quite nicely to other major asset classes.

Exhibit 3

Investment implications

The last several years of relative market stability is likely to give way to higher levels of volatility as markets continue to reach new peaks and monetary policy normalizes. Investors should keep market volatility in perspective, invest over longer time horizons and maintain portfolio discipline. Those who can see beyond short-term volatility by focusing on these three principles will likely be rewarded for their patience and discipline.

The prices of equity securities are sensitive to a wide range of factors, from economic to company-specific news, and can fluctuate rapidly and unpredictably, causing an investment to decrease in value. Past performance is no guarantee of future results. Diversification does not guarantee investment returns and does not eliminate the risk of loss.

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