How to React to Recent Market Volatility

How to React to Recent Market Volatility

While it may be difficult to remain calm during a substantial market decline, it is important to remember that market volatility is a normal part of the investment landscape.

In recent days the increase in volatility in the stock market has resulted in renewed anxiety for many investors. 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 market volatility may be more detrimental to portfolio performance than the drawdown itself.

Intra-year Declines

Exhibit 1

Market Volatility - intra year graph
In US dollars. US Market is 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. Data is calculated off rounded daily returns.

This shows calendar year returns for the US stock market since 1979, as well as the largest intra-year declines that occurred during a given year. 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%. Despite substantial intra-year drops, calendar year returns were positive in 33 years out of the 40 examined.

This goes to show just how common market declines are and how difficult it is to say whether a large intra-year decline will result in negative returns over the entire year.About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops, calendar year returns were positive in 33 years out of the 40 examined.

This goes to show just how common market declines are and how difficult it is to say whether a large intra-year decline will result in negative returns over the entire year.

Reacting Affects Performance

If one was to try to time the market in order to avoid the potential losses associated with periods of increased market volatility, would this help or hinder long-term performance? If current market prices aggregate the information and expectations of market participants, stock mis-pricing cannot be systematically exploited through market timing.

In other words, it is unlikely that investors can successfully time the market. If they do manage it, it may be a result of luck rather than skill. Further complicating the prospect of market timing being additive to portfolio performance comes from just a handful of days. A substantial proportion of the total return of stocks comes from long periods – not just a few days. Investors are unlikely to be able to identify in advance which days will have strong returns and which will not. Therefore, the prudent course is likely to remain invested during periods of volatility rather than jump into and out of stocks. Otherwise, an investor runs the risk of being on the sidelines on days when returns happen to be strongly positive.

Impact of Missing Out

Exhibit 2

Market Volatiity - missing a few strong days
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). Annualized returns for the missed best day(s) were calculated by substituting actual returns for the missed best day(s) with zero. S&P data © 2019 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. By adhering to a well-thought-out investment plan, ideally 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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Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

  • Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.
  • Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.
  • There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.
  • All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.

About the Author Doug Finley

Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.

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