Keep calm and carry on

After a period of relative calm, the stock markets have recently experienced some increased volatility. This has caused understandable anxiety for many investors – but holding your nerve remains the best response.

While it may be difficult to remain calm during a substantial market decline, it is important to remember that volatility is a normal part of investing. Additionally, for long-term investors, reacting emotionally to volatile markets may be more detrimental to portfolio performance than the downturn itself.

Intra-year declines
Graph 1  shows calendar year returns for the US stock market since 1979, as well as the largest intra-year falls. During this period, the average intra-year decline was about 14%. About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. However, despite substantial intra-year drops, calendar-year returns were positive in 32 years out of the 37 examined. This shows that falls in markets are common – and that a large intra-year decline doesn’t necessarily mean that investors will experience negative returns over the entire year.

Graph 1. UK Market Intra-Year Gains and Declines vs Calendar Year Returns, 1979-2017U

In US dollars. US Market is measured by the Russell 3000 Index. Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

Reacting impacts performance
If an investor tried to time the market in order to avoid the potential losses associated with periods of increased volatility, would this help or hinder long-term performance?

If current market prices aggregate the information and expectations of market participants, stock mispricing cannot be systematically exploited through market timing. In other words, it is unlikely that investors can successfully time the market, and if they do manage it, this may be a result of luck rather than skill.

One important complicating factor is that a substantial proportion of the total return of equities over long periods comes from just a handful of days. Since investors are unlikely to be able to identify in advance which days will have strong returns and which will not, remaining invested during periods of volatility is likely to prove the prudent strategy. Jumping in and out of equities is unlikely to be successful, because an investor runs the risk of being on the sidelines on days when returns turn out to be strongly positive.

Graph 2  helps to illustrate this point. It shows the annualised compound return of the S&P 500 Index going back to 1990 and the impact of missing out on just a few days of strong returns. The bars represent the hypothetical growth of $1,000 over the period: the highest bar shows the best possible return, while the lower bars reveal the impact of missing the best single day during the period, the best five single days, and so on. The data shows that being on the sidelines for only a few of the best single days in the market would have resulted in substantially lower returns than the total period had to offer.


Graph 2.    Performance of the S&P 500 Index, 1990–2017

 

In US dollars. For illustrative purposes. The missed best day(s) examples assume that the hypothetical portfolio fully divested its holdings at the end of the day before the missed best day(s), held cash for the missed best day(s), and reinvested the entire portfolio in the S&P 500 at the end of the missed best day(s). Annualised returns for the missed best day(s) were calculated by substituting actual returns for the missed best day(s) with zero. S&P data © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. One-Month US T- Bills is the IA SBBI US 30 Day TBill TR USD, provided by Ibbotson Associates via Morningstar Direct. Data is calculated off rounded daily index values.

Conclusion
While market volatility can be nerve-racking for investors, reacting emotionally and changing long-term investment strategies in response to short-term declines could prove more harmful than helpful. The best approach is to develop a well-thought-out investment plan – and then stick with it. If the plan is agreed upon in advance of periods of volatility, investors may be better able to remain calm during periods of short-term uncertainty.
 

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