You may have noticed some scary headlines recently…
Dow Plummets 700+ Points – Stocks Post Largest One-Day Loss in 2019
U.S. Trade War with China Intensifies
Inverted Yield Curve Predicts a Recession
…and you may also have noticed the resulting increase in stock market volatility.
Does this make you nervous? Should you alter your investment portfolio? What is an investor to do?
I am here to tell you to take a deep breath.
It is important to understand that market volatility is normal and the level of volatility ebbs and flows all the time. Headlines may be attention grabbing, they are meant to be. That’s what attracts eyeballs and that’s what advertisers pay for. But they should not cause you to alter a well planned investment strategy.
During your investment timeframe (provided it is long-term) you will most likely encounter numerous small and medium-sized declines – and most likely a few very large ones, as well. Here are some interesting stock market statistics.
Frequency of Corrections
According to a recent study done by Capital Group, over the past 70 years (from 1949 through 2018), examining the Standard & Poor’s 500 Composite (S&P 500) Index declines of
- 5%+ occur about 3 times per year on average;
- 10%+ occur about once per year on average;
- 15%+ occur about once every 4 years; and
- 20%+ occur about once every 7 years.
As you can see, run of the mill 5% and 10% declines are quite commonplace and are just par for the course in any given year. This normal volatility is to be expected. (Although, as an aside, there was a lengthy period during 2016 to 2017 where we didn’t experience any declines of 5% or more.) Bigger declines of 20% or more, the definition of a bear market, should be expected to occur at least once every decade.
If your investment time horizon is long enough, which would be expected for someone investing during their working years and through retirement, you will likely encounter a number of bear markets. The first gut-wrenching 20%+ drop you experience will likely be the most uncomfortable as it will be new to you. However, as I can personally attest, each one gets easier to digest as you become a more experienced investor. It is important to remain rational in times of turmoil and refrain from responding to a decline with panic.
You will ultimately regard large market disruptions as normal, albeit infrequent, occurrences that may be annoying to observe while also possibly testing your fortitude. If you shift your mindset to that of an investment owner, as opposed to one of an investment speculator, you may even begin to see these market corrections as opportunities rather than worries.
Mr. Market – Ownership versus Speculation
Let’s take a step back and contemplate what it means to buy a stock (or a fund that owns stocks). For discussion purposes, we’ll assume the investor purchases an S&P 500 Index fund. When purchasing a share of one of these funds, you are buying a small piece of every company in the index. This particular index is comprised of 500 of the largest U.S. publicly traded companies.
As an owner of these companies, you own a proportional share of the earnings of each company and have a right to your share of dividends. It is helpful to think in these terms when markets become volatile. Your ownership hasn’t changed, you own the same companies in the same portions, only the price of the index has changed. Your share of each company’s earnings and dividends are the same.
Chapter 8 in The Intelligent Investor by Benjamin Graham entitled The Investor and Market Fluctuations contains a famous metaphor of “Mr. Market” which creates a visual example that can greatly aid in understanding this important concept.
Think of the stock market as a business partner, Mr. Market, who is constantly offering to buy your shares or sell you his shares every day. Mr. Market is sort of manic depressive – some days he is really enthusiastic and will offer you much more than he has in days or weeks prior and at other times he is depressed and will offer far less than previously.
You have the luxury of choosing to ignore Mr. Market at will, or trade with him if it suits your desire. You are never forced to sell your shares and are free to disregard Mr. Market and his emotions.
To quote Ben Graham:
“The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.”
Volatility During Wealth Accumulation
The effects of market volatility can best be viewed through two different lenses depending on your location along your investment timeline. For those in the accumulation stage, volatility is probably best ignored. In all likelihood, you are making consistent contributions to your investment portfolio and volatility can actually be beneficial.
When prices are lower, you are able to purchase more shares and thus more earnings and dividends with each investment dollar. When prices are higher, your dollar purchases fewer shares. This is a form of dollar cost averaging. More shares are accumulated at lower prices and fewer shares at higher prices.
During the wealth accumulation stage, a high equity allocation can often be advantageous and volatility shouldn’t be a major concern. With full comprehension of the Mr. Market concept and collective understanding of the underlying business fundamentals of the diversified group of companies I owned through various mutual funds, I was comfortable having very close to 100% of my portfolio in equities during my accumulation years. (This is just my own personal experience and not to be construed as a recommendation.)
Volatility at the Goal Line
Once an investor is near the point where withdrawals will soon begin (i.e. retirement), volatility is of greater concern. When one begins drawing down a portfolio, the matter of sequence of returns risk becomes an issue. Large market declines in the early years of a portfolio in drawdown mode can have a devastating effect on portfolio longevity.
It is during this decumulation stage that appropriate asset allocation is paramount. Safe withdrawal rates are also very important during this stage. For an in depth analysis of safe withdrawal rates, sequence of returns risk and asset allocation strategies during retirement, I highly recommend the Safe Withdrawal Rate Series at Early Retirement Now.
Now that I am in the drawdown stage of my investment timeline, my asset allocation has become more conservative to mitigate my sequence of returns risk. As you might suspect, I am comfortable with a very high equity allocation. Even so, during my retirement years, I have chosen to implement what is referred to as a rising equity glidepath. The plan for my portfolio allocation is for it to gradually rise from 70% equity / 30% fixed income at initial retirement to 90% equity / 10% fixed income over a 10-year period. (This is my personal plan and is not meant to be a recommendation.)
When markets become volatile a little trick I use is to jokingly admonish Mr. Market. When there is no fundamental change to an investment I own, I will often quip, “Mr. Market is at it again!” This helps remind me that markets are naturally volatile and no action is required on my part.
As Jack Bogle, pioneer of the index fund and the founder of The Vanguard Group, was known to say – “Stay the course.”
Lastly, if volatility still gets under your skin and you feel like you want to do something – against better judgment – before you do anything rash, sit back and watch this YouTube video by JL Collins:
A Guided Meditation for When the Stock Market Is Dropping.
Enjoy the journey!