Finance

The Face of Volatility

I get nervous when I begin to see a false sense of security among my clients. Investors may fear the worst (“I just don’t want to go through another 2008!”) but often bank on earning …

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I get nervous when I begin to see a false sense of security among my clients. Investors may fear the worst (“I just don’t want to go through another 2008!”) but often bank on earning consistently good returns in years when the markets aren’t panicked.

We haven’t seen a lot of market volatility for quite a while. As of February 24th, 30 months have elapsed from the last correction (a 10% drop in stock prices). Since 1980, according to J.P. Morgan Asset Management, intra-year declines of the S&P 500 have averaged 14.7%. However, the last 24 drawdowns (since 2009) have averaged only 6.9% and lasted approximately 18 days. That makes for pretty calm waters.

Unfortunately, market declines can happen when you least expect them. To quote research completed by Stock Trader’s Almanac, “….more than half of all bear markets over the past 114 years have occurred without a recession or began more than a year before a recession.” That means you can’t always blame a rotten economy for your poor stock returns and you aren’t necessarily safe even if you are feeling pretty confident.

Here are a couple of helpful insights into volatility that investors can overlook:

There are many causes of market corrections: bubbles (technology in 2001), banking issues (2008), and exogenous factors from overseas (Greece in 2010 and 2011) to name a few. Often times it takes more than one piece of bad news to get a bear market going. Thus, while the headlines can be crowded with stories of social unrest, currency devaluations, and weakened foreign economies, global contagion can be a relatively rare occurrence. On the other hand, seemingly small incidents may blow up into big ones without much warning (1997 Asian Financial Crisis). Hindsight unfortunately may be the best predictor of market declines.

Good stuff gets sold along with bad stuff. When volatility does occur, it can happen fast and affect parts of your portfolio you never expected to be vulnerable. A number of assets have a reputation of being easy to get into and hard to get out of. That means you can’t always sell them for a good price when you want to. At the same time, traders and fund managers often borrow money to make portfolio purchases. When markets decline, these traders need to raise cash to support or exit leveraged positions. The result is that sometimes sellers dump their best liquid assets (your star performers!) not just the assets in trouble.

A sideways market can be your friend. 2013 was a great year for investors, but euphoria can quickly lead to impatience when markets stall out. What is easily forgotten is that volatility that takes place within a trading range allows markets to digest gains before moving ahead again. Most money managers welcome a period of consolidation after a big market increase, as it may reduce downside risk in the future. Markets that don’t stall out on occasion can lead to bubbles.

While 2014 could very well produce gains for investors, volatility could return to a more typical pattern of equity corrections exceeding 10%. Since complacency encouraged by up markets can result in poor judgment calls in down markets, my advice is to plan ahead now and select a portfolio that will allow you to weather any possible future volatility.

Betsey Purinton, CFP® is Managing Director and Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at bpurinton@strategicpoint.com. The information contained in this report is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein.