In my hometown of Baltimore, there’s an oft-heard saying that seems especially applicable when, like now, the seasons are changing: “If you don’t like the weather today, just wait until tomorrow.” For whatever meteorological reason, it’s not uncommon for an absolutely miserable Monday to turn into a gorgeous Tuesday. Temperatures have been known to swing as much as 20 degrees inside of an afternoon.
A scientific view of stock market history, unfortunately, shows us an even greater propensity for unpredictability and volatility.
Even the years that we refer to as the “good” ones, in retrospect, test our mettle. For example, between 1950 and 2014, a span of 65 years, the S&P 500 ended the year with a gain 51 times (or in almost 80% of them). Not bad. But in how many of those up years do you think investors would’ve found themselves in a “losing” position at some point in the year?
Every. Single. One.
That’s right, from 1950 through 2014, an investor in “the market” would have felt the pain of intra-year declines 100% of the time. As we shorten the time horizon, we find even more instability. Indeed, 70% of quarters in this period netted a positive return while only 63% of months were up. And some of these down months were really down. Losses exceeded 5% in 182 months during this period and 10% in 31 months, despite a 65-year stretch that rewarded investors with an 11.4% annualized rate of return.
What’s the point?
Volatility is how the market works. It’s a necessary byproduct of investing. Indeed, the very same elements of investing in the market that test our mettle and inspire doubt—volatility and unpredictability—also justify our expectations of higher returns over time. It is our willingness to endure disappointing months, quarters, years and perhaps even longer cycles of the market that makes it possible—and according to the evidence, probable—to earn the higher returns most of us need to meet our financial goals in life.
Does that mean you should dump the entirety of your nest egg into an S&P 500 index fund and white-knuckle your way through the toughest times?
Determining How Much Risk You Can Handle
We invest in stocks to make money; we invest in bonds to dampen the volatility of a portfolio so we can stay invested in stocks in down markets. Therefore, the question becomes: How much volatility—stock exposure—can we handle based on our ability, willingness and need to take risk?
Your ability to take risk is a common factor in determining an appropriate asset allocation, especially in target-date mutual funds. It’s your time horizon, and the more time you have between today and when you need the money you’re investing, in general the more risk you’re able to take. But while your ability to take risk is the primary (and often only) factor considered in most of the financial industry’s modeling, it’s not even the most important element to consider.
Your willingness to take risk should be the foremost driver of your asset allocation decisions, because a plan abandoned is no plan at all. This is the gut check, and it’s imperative that you are honest with yourself. How much volatility could you handle without abandoning your strategy? Consider using this chart as a guide:
What is your maximum tolerable loss? I’ll warn you that this is a trickier question to answer than it initially appears. If you’re answering it in the midst of trying times for the market, your response could vary dramatically from when it’s posed as a hypothetical. A helpful way to improve the veracity of your answer is to translate percentages to dollars. For example, if you have $1 million in your portfolio, what loss would be your breaking point? $200,000? $300,000? If you could reasonably expect to stick with the plan if you lost 20%, but not 30%, you likely shouldn’t have more than 50% or 60% of your portfolio invested in equities.
What about the other part of your portfolio? You’ll read articles suggesting that an imminent, expected rise in interest rates should translate into an overhaul of your fixed income strategy. Trading your conservative bond positions for higher-yield bonds and/or dividend-paying stocks, however, contradicts the fundamental reason for holding bonds in the first place—to stabilize your portfolio. Therefore, consider risking abject boredom with your fixed income allocation, investing in short-term Treasuries, FDIC-insured CDs and only the highest-rated, diversified municipal bonds when applicable. These securities typically should not respond with high volatility if or when interest rates rise. On the other hand, corporate bonds, junk bonds and income-oriented equities react very much like stocks in times of volatility, thus eliminating the steadying influence we expect from the fixed income portion of a portfolio.
But what if you say, “Heck, I don’t want to lose anything!” That’s when it’s time to consider your need to take risk. If you insist on preserving 100% of your capital, the only securities you should own are those backed by the full faith and credit of the U.S. government (they’re the only securities considered to be free of “default risk”). However, as you might expect, they don’t pay very much (especially now) because you risk so little. So, if you need an annual rate of return of 6% in order to meet your long-term financial goals, you’ll likely need to take some equity risk to give yourself a chance. You couldn’t reasonably expect to do so by investing solely in the most conservative fixed income vehicles.
Fear of Volatility Intensifies In Retirement
The reality of market volatility can become a source of great challenge, especially for those at the front end of their retirement. Retiring is one of the most stressful events in people’s lives, in part because we relinquish control over our income—our wherewithal and, apparently, our wellbeing.
For most retirees, the only way to outlive their money is to risk losing it by investing a meaningful portion of their savings in a way that’s exposed to stock volatility. Early retirees check their investment portfolios with great frequency, living and dying on the latest month or quarter’s performance. But as we’ve seen, investors exposed to the market should expect to suffer portfolio declines in roughly 40% of months, 30% of quarters and at least 20% of years.
Retired or not, is it possible that the next time you open a statement and see a drop in your portfolio balance, you could simply remember that your willingness to brush off short-term volatility is precisely the reason you can expect to enjoy a higher long-term return?
Special thanks to my colleague, Kevin Grogan, co-author of Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility, for pointing me to the optimal research for this post.
This commentary originally appeared November 22 on Forbes.com
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