Understand Volatility
“A smooth sea never made a skilled sailor”
A market without volatility would be unnatural, like an ocean without waves. The free market, like the open ocean, is constantly churning. For some investors, market-moving waves can be exciting, providing a buying opportunity for mispriced securities. For other investors, the waves might feel violent; but truthfully, for long-term investors, market volatility should be irrelevant.
The degree of market volatility varies from small ripples, to rolling waves, to a financial crisis-sized tsunami. While all volatility feels uncomfortable in the near term, the important question for long-term investors is how to respond to it. In this bulletin we outline four principles that will help investors navigate a choppy market.
Expect bigger waves
We are entering the later stages of a long economic expansion. While we expect a healthy, growing economy in the coming year, it is important to acknowledge that volatility tends to be elevated in the second half of the business cycle. To expand upon our nautical metaphor, we liken the cyclical nature of volatility to the ocean tide. Volatility ebbs with the positive and steadfast economic news that characterizes the beginning of the business cycle, and it flows when the market is mired by slowing economic momentum and fears of recession. Exhibit 1 illustrates this concept over the previous three business cycles.
Skittish investors who are skeptical of the prospects of future economic growth are the main cause of the bigger waves at the end of the cycle. When there are fears of a recession, investors’ “edge of seat” mentality causes quick and sometimes irrational decision making, and the subsequent herd behavior can amplify the market drawdown and ultimately cause tsunami-magnitude volatility.
Grab an oar! Here is what you will need to do…
Actually, as a long-term investor you’ll need to do less than you think. Your diversified portfolio was built to feel steady in rough seas.
1. Remember that volatility is normal.
Volatility in the market is normal, and feeling uneasy about a lower portfolio value is normal too. Illustrating how often investors experience moderate pullbacks is simple enough. Exhibit 2 depicts the number of 5% pullbacks experienced each year. The chart reminds us that even in years with outstanding equity returns, there are rolling waves of volatility in the market. What we cannot show in a chart is the seasickness an investor feels while riding these waves to a lower portfolio value.
Historical analysis shows that pullbacks of 5% have occurred about once a quarter, and pullbacks of 10% are likely to occur once per year. Large pullbacks greater than 20% tend to occur just once per market cycle. A savvy investor will recognize the high frequency of equity market volatility, and will determine the source of the volatility before reacting to it.
2. Do not jump ship at the bottom: Markets tend to rebound after bouts of volatility.
Focusing on the long-term trends of the market rather than the short-term gyrations should give investors the confidence to ride the waves of volatility. When examining historic equity market data, we see a trend of rebounds following equity market pullbacks. That means that investors who jump ship after a big wave may have broken the cardinal rule of investing by “selling low.”
Exhibit 3 shows the largest intra-year decline and the calendar year return every year since 1980. Despite an average intra-year drop of 14.2%, the market ended the year higher than it began it 76% of the time. That is why it is important for investors to ride the wave of volatility through its full cycle.
Michael D. Green, Principal
TGA Capital Management.Com
25 Braintree Hill Office Park
Braintree, MA 02184
A Registered Investment Advisory, RIA
Mgreen@tgacapitalmanagement.com
https://www.linkedin.com/in/tgagiacapitalmanagement
1.508.224.9646
This is not a solicitation nor recommendation to buy or sell a securities nor to imply any tax or legal advice, always seek a registered investment advisor to attain your risk/averse attitude and investment suitability before investing. All information is considered accurate and reliable, however, due to changing market, economic, taxation, institutional, and other pertinent potential cycles and variations, future results cannot be guaranteed by past performance and should be monitored on a continual periodic systematic basis to provide current advisory recommendations that meets the client short-term potential deviations and management disciplined style, while advisory provides solely long-term recommendations.
Confidentiality Notice. The information in this e-mail and any attachments is confidential and may be privileged or protected by other rules, including but not limited to the Electronic Communications Privacy Act, 18 U.S.C. §§ 2510-2521. It is intended solely for the addressee(s). Access to this e-mail by anyone other than the addressee(s) is unauthorized. If you are not the intended recipient, you are not authorized to and therefore must not disclose, copy, distribute or retain this message or any part of this message.