February 9, 2016
February 9, 2016
For the past few years, investors who own U.S. stocks enjoyed an extended stretch of rising prices. This peaceful market changed in August, however, when volatility spiked.
And more often than not, volatility is coupled with a steady stream of dismal news and scant mention of disciplined investing. This time has been no exception.
Specifically: Investors have had to reassess their outlook for China’s growth following an unexpected devaluation of the yuan. The blistering price volatility in China’s local stock market has also been a focal point, even though this market is not investable for most foreigners. And investors have considered an increase in interest rates here in the United States, anticipated to occur sometime before year’s end.
Additionally, investors have turned their attention to high valuation levels for U.S. stocks based on various metrics, including the cyclically-adjusted price-to-earnings ratio (CAPE) developed by Robert Shiller at Yale. CAPE smooths valuations by using the average earnings from the previous ten-year time period. Even though CAPE shows valuations in the United States as currently above historical averages, this tool does not tell us when prices will revert to the mean. Even so, high valuations can make investors even more skittish during times of volatility.
What’s more, sometimes even good news can be bad for stocks. Again, all of us enjoyed paying less at the gas pump earlier this year as energy prices dipped to multi-year lows. Most recently, however, investors have perceived the decline in oil prices as a sign of slowing growth worldwide, a negative for stocks. In other times, and maybe in future periods, these lower prices could be a reason to be optimistic about stocks. Lower raw material costs can boost corporate earnings and consumers paying less for energy could have more money to spend on other goods and services.
The bottom line is that, for whatever reason, volatility exists and is normal and inevitable. J.P. Morgan charts the annual volatility of the S&P 500 index and notes that the average intra-year decline for stocks was approximately -14 percent over the past 35 years. Still, during most of those years, stocks finished in positive territory. The recent volatility in stock prices is within this “normal” range; it is the calm and steadily-rising market of the prior years that is the anomaly.
When volatility emerges, many investors feel that they should do something—anything—other than stick with their disciplined plan. Unfortunately, the long-term returns available from owning stocks can be lost by an investor who lets emotions dictate his or her actions during times of market turmoil. So, what is an investor to do?
First, we should acknowledge that investing has an emotional component. Investors may abandon their discipline during periods of both rising and falling stock markets. It is wise, then, to assess risk tolerance on an ongoing basis and to keep risk levels under control.
Second, we should recognize that volatility occurs regularly and that the reasons for it always feel unique and disastrous. These feelings will likely be nourished by a steady diet of downbeat news, citing seemingly plausible evidence that this time is different.
Third, investors should embrace a portfolio that will serve them through both rising and falling markets. Trying to time the markets is difficult, so for our clients, we recommend mitigating losses by maintaining some allocation to stable assets in all market conditions. Bonds are likely to provide lower returns than do stocks in most time periods, but the stability provided in times of volatility could be just the ticket to helping an investor stay disciplined. And discipline is what counts now.