Though it is impossible to predict the future, expecting volatility in the coming years is a safe bet. Market volatility is normal.
It is especially important to be mindful about how to dampen portfolio volatility in the later stages of the business cycle.
Investing with a long time horizon and through a diversified portfolio are the best ways to batten down the hatches against volatility and avoid emotional investing errors like selling the market at the bottom.
“A smooth sea never made a skilled sailor”
A market without volatility would be unnatural, like an ocean without waves. The free market, like the open ocean, is constantly churning. For some investors, market-moving waves can be exciting, providing a buying opportunity for mispriced securities. For other investors, the waves might feel violent; but truthfully, for long-term investors, market volatility should be irrelevant.
The degree of market volatility varies from small ripples, to rolling waves, to a financial crisis-sized tsunami. While all volatility feels uncomfortable in the near term, the important question for long-term investors is how to respond to it. In this bulletin we outline four principles that will help investors navigate a choppy market.
Expect bigger waves
We are entering the later stages of a long economic expansion. While we expect a healthy, growing economy in the coming year, it is important to acknowledge that volatility tends to be elevated in the second half of the business cycle. To expand upon our nautical metaphor, we liken the cyclical nature of volatility to the ocean tide. Volatility ebbs with the positive and steadfast economic news that characterizes the beginning of the business cycle, and it flows when the market is mired by slowing economic momentum and fears of recession. Exhibit 1 illustrates this concept over the previous three business cycles.
Skittish investors who are skeptical of the prospects of future economic growth are the main cause of the bigger waves at the end of the cycle. When there are fears of a recession, investors’ “edge of seat” mentality causes quick and sometimes irrational decision making, and the subsequent herd behavior can amplify the market drawdown and ultimately cause tsunami-magnitude volatility.