Investing in Volatile Markets
Enjoy this week's edition of the Planner's Beta
Beta (n) - climber's jargon that designates information about a climb
In today's video, I want to help you better understand the nature of volatility and why it's important to remain invested during volatile markets.
Whether you're a new investor or a seasoned investor, it is vital to remind yourself of the relationship between risk and return. It is also essential to understand the historical context of volatility or the ups and downs.
Graphs are worth a thousand words. And a chart that provides volumes of insight for investors is the historical price return of the S&P index going back to 1928. Just as a reminder for those new to investing, the S&P 500 represents the 500 largest companies publicly traded by market capitalization. Market capitalization is the total dollar market value of a company's outstanding shares of stock.
Since 1928, a nearly century-long term timeframe, the S&P experienced significant bouts of volatility and uncertainty. During this timeframe, the markets weathered a depression, a world war slow-burning conflicts all around the globe, periods of heightened inflation, flash crashes, a tech bubble, a housing bubble, and most recently, a pandemic. And despite all of the volatility, the S&P provided an average return of 6% per year before dividends.
And this is a pattern investors expect to see into the future. As investors, we are placing our hard-earned money at risk. But, unfortunately, taking risks is the price we pay for the cost of admission to have the opportunity to grow our wealth. Investors demand returns for the risk they take. And as we can see, long-term investors were rewarded for taking these risks. Therefore, investors should remain focused on the long run to benefit from the expected growth.
Now, let's zoom in a little bit to look more at the nature of volatility within the last 40 years. This graph shows the number of S&P 500 5% pullbacks that occurred each calendar year going back to the 1980s. There have only been three other instances in the past 40 years where investors did not experience a 5% pullback within a calendar year. And on average, the index provided between four and five retreats within the year. It is also vital to note there can be periods of increased volatility and uncertainty. We can see that clearly in this graph by looking at 2020. We can look back at the Great Financial Crisis in the 2007-2010 time frame and the Tech Bubble during the early 2000s to understand the nature of volatility during uncertain times.
Now let's look at the data a little bit differently. First, we looked at the frequency of 5% pullbacks in the S&P, but we have not answered the question, "What are some of the significant declines investors can expect?" We can answer this question by looking at the total returns of the S&P 500 on the calendar year and the max drawdown within the year.
In this illustration, we can see the max drawdowns by year indicated by the dots. And we can see the end of year returns shown by the bars. We can see that there are periods where there can be significant drawdowns. We can also see that there can be periods where on the calendar year, the S&P performs well.
Looking at 2020, we can see that the S&P Total Return Index experienced a 34% decline. But on the calendar year, the index was up 18%. Now, a 34% decline sounds like a lot, but it was worse if you go back to the Great Financial Crisis. During 2007, the index experienced a 48% decline. And on the calendar year, the index finished down 37%.
The other thing to take away from this graph is that there can be periods of increased uncertainty. But we can see more years when there were gains on the calendar year than losses, especially with dividends. So, we can infer from this graph that investors who remained invested during this period in products that closely tracked the S&P index were rewarded for taking risks during this time frame.
Now, we need to remember that investing is very personal for each individual. Each investor's portfolio should be unique to their circumstances. Because the barriers to investing have fallen so much in the past two decades (which is a good thing!), it's easy to just go and start investing. Investors can often begin investing without a purpose or strategy, and when volatility returns, it can play on their emotions. These emotions, in turn, impact their behaviors and, ultimately, the performance of their portfolio. Now that you have had a chance to understand the nature of volatility in asset prices, would you have stayed invest during the Great Financial Crisis?
When headlines become ominous or the worst days seem yet to happen, investors often begin to time the market. And from looking at the data, timing the market is extremely hard to do successfully. And it can be costly.
So let's look at the cost of trying to time the market. In this graph, we can observe the effect of exiting the market the day after a 2% decline, or worse, and staying out for the period shown. This graph looks at the past 25 years of the S&P 500 returns. It excludes transaction costs incurred by the investor.
If we take an investor who invested in a mutual fund or ETF for 25 years, which precisely tracked the S&P 500's returns, then that thousand dollar investment would have grown into roughly $5,500. Not bad, considering this investor did not try to time the market.
Now, let's look at a separate investor. Let's say that this investor didn't have a well-constructed portfolio, and they just went into investing without a strategy. This investor is nervous about the market going up and down, so they tried to time it. Each time this person experienced a 2% decline or more in the market, they sold their precisely tracking the S&P500 index ETF or Mutual Fund. In that case, if they waited one week and then reinvested, that person's portfolio would have only grown to about $2,300 before transaction costs. That is significantly worse than the individual who just stayed fully invested. So it's tough to time the market.
We don't know when the market will be up and when it is going to be down. So to successfully time the market, you have to be correct twice. You need to know when to leave the markets. And you need to know when to return to the markets. So this is why it is difficult to time the market. And as we can see in this graph, if you are somebody who jumps in and out of the market frequently, it can potentially significantly decrease your returns.
It is vital for individuals to invest with a purpose and clearly articulate their goals, risk tolerance, and capacity. And that's why I encourage folks, whether new or seasoned investors, to continually educate themselves about investing. And that they continuously monitor their financial plan. Understanding the nature of volatility, the value of staying invested, and the importance of a well-crafted portfolio are crucial for increasing your potential success.
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