Volatility is a Good Thing!

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“You can relax in the sense that you know the animal you’re riding, and it could turn out well. It could turn out badly over short periods of time. But it is the animal that you know.” -- Eugene Fama

“A big challenge for an advisor is to help clients understand that this was a normal outcome and that, ‘No, we don’t need to adjust our portfolio because this quarter it went down. This was in the range of perfectly reasonable outcomes.’” -- Kenneth French 

Many readers may call us crazy, but hear us out.

The beginning of 2016 has been tumultuous to say the least. Concerns over China’s transition from an export based economy to a more developed economy based on its own aggregate demand, as well as moving from a pegged currency has global investors very nervous. How does the largest economy in the world evolve into what it needs to become in order to have sustained growth over time? Similarly, news about oil prices, the possibility of Great Britain exiting the European Union, and prognostications of a global economic slowdown have all led to the recent flurry of stock market activity.

First, we would like to mention that volatility is a good thing. It reflects a properly functioning market. With more uncertainty, we would expect more fluctuation in market prices. Since market prices reflect future expectations and risk preferences, more uncertainty around future expectations would result in wider swings in market prices. This is the basis of the Hebner Model. In fact, we should embrace market volatility as it ensures that prices are digesting information and setting a positive expected return going forward. It doesn’t mean that everyday we will see a positive outcome, but we will see more positive outcomes than negative. If not, then nobody would invest in the capital markets.

In the month of January, the S&P 500 Index lost -4.96%, its ninth lowest return of the index since 1926.[i] IFA Index Portfolio 100, which is our globally diversified portfolio of equities with tilts towards small cap and value stocks, lost -6.25% during the same time. Should investors take these losses as signs of more financial pain to come?

Of course not!

We say this with confidence because history has been on our side. The benefit of having hard-nosed data is that we don’t have to rely on gut instincts or random guesses. While we would never say with absolute certainty what the future holds, we can observe similar market environments in the past to give us some degree of insight. There will always be those investors who believe that “this time is different,” to which we would respond, “that is what most people with gambling problems say as well.”

Going all the way back to 1926, whenever a year started off with a negative January the subsequent 11 month period was positive 59% of the time, with an average return of approximately 7%. Further, from its most recent peak on November 3 of 2015, the S&P 500 has lost -10.43% through January 15, 2016. We can look into subsequent 1, 3, and 5 year annualized returns across domestic, international developed, and emerging markets after similar declines. The table below shows these exact metrics.

For example, for US Large Cap stocks there have been 152 periods from 1926 through 2015 where there have been 10% declines. The subsequent 1, 3, and 5 year annualized returns were, on average, 11.95%, 8.94%, and 10.07%, respectively. Similarly, when the US Large Cap stocks have declined by 20%, which has happened 39 times in the past, subsequent returns have been 10.43%, 7.58%, and 9.63%, respectively. There have been similar trends across the international/developed and emerging markets as well.

Negative returns don’t necessarily lead to further negative returns. In fact, history seems to suggest the opposite. But what about volatility? Volatility measures both down and upside movements within the market and many professional traders believe it to be a great technical indicator. Unfortunately, volatility does not provide much insight in terms of future expectations, at least over multiple years. Once we move outside daily, monthly and even annual volatility estimates, which many statisticians have described as “random noise,” volatility (as measured by standard deviation) and realized returns have had a very loose relationship. Grouping the returns of the S&P 500 Index by decade going back to 1930, we can see that there have been periods of high volatility and high returns, high volatility and high realized returns, low volatility and high realized returns and low volatility and low realized returns. See table below.

The markets have tested investor discipline so far this year. While the S&P 500 has delivered its ninth worst performance in measured history, we need to be careful about extrapolating these results into the future. History has shown that more often than not, a deep decline has usually resulted in favorable returns for investors over subsequent short term time periods. Although times are volatile, we should embrace market volatility as it indicates a properly functioning market. More uncertainty should lead to more volatility. Nobody knows for sure what the future will hold, but if it is anything like it has been in the past, then investors should be excited. As always, maintaining discipline through all market environments is essential. Abandoning long term discipline and inviting short term emotion more often than not leads to bad financial outcomes.

Strap in and hold on for the ride.

[i] Dimensional Fund Advisors. Recent Market Volatility. Dimesional Fund Advisors, LP: February 2016.