1. 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.

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.

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.