Long-term investors should look beyond stock market volatility
Waddell & Reed Investors Series – December 2011
Long-term investors should look beyond stock market volatility
One definition of volatile says the word means “tending to rapid and extreme fluctuations.” Some would say that also defines the stock market, given the price movements in recent years. While stocks can be volatile, especially in response to major domestic or world events, historical market data show that prices typically have returned to less volatile patterns over time. That can be good news for long-term investors.
The 2008 credit crisis led to considerable fear and uncertainty about the global economy, which in turn contributed to significant volatility in stock prices. Global stock markets plummeted when the crisis first took hold, recovered in 2009 and then stumbled again. The lack of a clear solution for sustainable worldwide economic growth and expanding problems in Europe’s sovereign debt markets combined to hurt investor confidence and prompt many to look for ways to reduce risk.
When it comes to the stock market, volatility typically refers to the size and frequency of price movements. Volatility can be shown using standard deviation, a measure of the variance in the returns of a given security or market index. In general, higher volatility means a wider range of potential values for a security or index, and the possibility of sharp movements over short time periods – whether up or down.
The volatility in global markets in recent years has caused some to suggest the current period is more volatile than at any point in recent decades – and perhaps the onset of a “new normal.” While history cannot predict where the market is headed, a review of market volatility over time can be helpful in assessing the current situation.
Volatility shows historical patterns
An analysis of data back to the 1929 stock market crash shows that periods of volatile price movements have not been unusual. Volatility historically has increased sharply during times of major global events or economic disruption, and then gradually has declined to what might be considered more normal levels, often after the triggering issues are resolved.
The green line in the chart below shows the historical mean, or average, level of standard deviation – or volatility – in the stock market since 1926, as represented by the S&P 500 Index. The periods of increased volatility are the spikes above that line. The level of volatility and the length of time it stays above or below the average have varied widely in the market’s history.
History of Market Volatility
(annual standard deviation of S&P 500 Index, 12/31/1926 - 12/31/2010)
Events since 2008 – and especially in recent months – have again induced higher volatility into the stock market as a whole. Mike Avery, President of Waddell & Reed Investment Management Co., says, “I think we’re in a period in which increased volatility is going to be more normal for a while. It may be that investors became comfortable in a period where volatility was relatively low, but the last three years changed all that.”
One indicator of the increase in volatility can be seen in the table at right, which shows the number of days when the stock market finished more than 2 percent higher or lower, based on the S&P 500 Index.
A review of the period from 2000 to the end of October 2011 shows that more than one-half of the stock market’s “up” and “down” days have been recorded since 2008. There was a similar increase in volatility early in that time period, which coincided with the end of the Dot-Com Bubble, the terrorist attacks of 9/11 and the onset of the Iraq War.
But in the intervening years – roughly 2003 to 2007 – the market recorded much lower levels of volatility. In fact, for three of those years, there were a total of only two days when the market was up 2 percent or more and there were no declines of that magnitude. All in all, it was a period of unusually low volatility in stocks.
Looking further into history, the decade of the 1990s generally had lower than average volatility in the stock market overall. But that period followed a highly volatile era that began in the mid-1980s and included the “Black Monday” stock market crash of October 19, 1987, when the S&P 500 Index fell more than 20 percent in a single day. A global stock market decline followed, and most major exchanges had declined by a similar amount by the end of that month.
More recently, the S&P 500 Index dove 6.7 percent on Aug. 8 and has moved since then within a broad – but volatile – trading range of 1,074 to 1,284. That includes a gain of more than 4.3 percent on Nov. 30.
Philip Sanders, Chief Investment Officer of Waddell & Reed Investment Management Co., says he thinks the markets could remain relatively volatile in the near term as investors watch for a resolution to the debt issues facing the U.S. and the European Union. “We think the volatility is likely to continue until there are stronger signs of policy direction and economic recovery,” Sanders says.
Perception affects strategy…and results
In his 1992 book Market Volatility, Yale University economics professor Robert J. Shiller took on the subject of price volatility. Shiller used statistical evidence to analyze whether price movements were the result of fundamental economic factors, or whether they were due to “changes in opinion or psychology” among investors. He wrote that economic value accounts for some aspect of price, but “…investor attitudes are of great importance in determining the course of prices of speculative assets. Prices change in substantial measure because the investing public en masse capriciously changes its mind.”
The sharp moves up and down in today’s markets can challenge even the most seasoned investors. When economic news or the market’s volatility becomes sufficiently unsettling, many investors decide to step to the sidelines and hope to “time” their re-entry to an improvement in market conditions.
But there’s a problem with that strategy: It is not possible to accurately predict the exact timing of market moves. History shows that long-term investment success is more likely to be the result of a consistent approach, based on time in the market – not market timing. Attempts to time the market also can lead to buying high and selling low, which is the opposite of a successful investing strategy.
Selling when markets decline or become turbulent can leave an investor on the sidelines when stocks change direction – which can happen quickly. For example, the S&P 500 made a one-day gain of 11.6 percent on Oct. 13, 2008, after eight straight sessions of falling prices.
The charts below make it clear that, even in volatile markets, missing just a few of the stock market’s best single-day performances could have a significant effect on your portfolio. While the effect on returns of the S&P 500 Index in the last 20 years is noteworthy, for example, it is even more compelling in just the past 10 years. Only a fully invested portfolio would have produced a positive return during that period, as shown in the chart at right.
In fact, some financial planners have noted that investors who move out of stocks during volatile markets may be trading one perceived risk for another form of risk. For example, holding cash in an attempt to avoid stock market volatility could raise the potential for missing longer term investment goals, as the real rate of return on cash currently is negative once the impact of inflation is calculated.
Looking beyond current markets
Increases in stock market volatility have been the norm in periods of uncertainty or as a result of major events for more than 80 years. When the outcome of such ”shocks to the system” become more clear or the events are fully resolved, investor confidence tends to rise and volatility tends to decrease to the historical mean. In the long-term, stock investors generally have been rewarded for patience and consistency, as shown in the chart below.
Although periods of volatility may be unnerving for individual investors, an experienced management team can distinguish between daily market noise and real long-term investment risks to position a portfolio accordingly. At Waddell & Reed, we look across the globe at all asset classes as we review investment opportunities. We think investors will be compensated over time for accepting volatility in the current market environment, in which we think extreme risk aversion has driven up the price of assets that are perceived to be safe and driven down the price of assets that may participate in future growth.
Performance Over the Long Term
(12/31/1925 - 10/31/2011)
Past performance is not a guarantee of future results. The opinions expressed in this article are those of Waddell & Reed and are not meant to predict or project the future performance of any investment product. The opinions are current through Dec 5, 2011, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.
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