The academic research clearly shows that periods of downside volatility are followed by periods of upside volatility. This can also be described by a phenomenon called 'reversion to the mean.' Essentially, this means that while markets are very noisy and can be quite volatile in the short run, prices do get back to some level of normalcy. This begets a very elusive question of timing: 'When will markets return to normal?'
Relatively speaking, stocks still look cheap next to bonds and cash. As the dust settles from these big market drops, markets will weigh their collective direction. On the one hand, you have rampant anxiety; on the other hand, you have attractive valuations. Patience will prove to be a virtue as the saga plays out and we eventually return to market fundamentals.
Unfortunately you cannot predict these volatile movements with any reliability. While this immutable fact is unsatisfying to many, ignoring it most often causes the unsatisfied (and unsophisticated) investor to make emotional decisions and miss the upside of the volatility and the reversion to the mean. Leaving investment decisions to emotions and pure chance is simply not a sound philosophy.
For more information, below is a good article from Jim Parker of Dimensional Fund Advisors that puts the current market volatility in perspective. It's a good, quick read.
Hang in there.
Kevin Kroskey, CFP, MBA
"Living With Volatility"
Jim Parker, VP, Dimensional Fund Advisors
The current renewed volatility in financial markets is reviving unwelcome feelings among many investors—feelings of anxiety, fear, and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing us more harm than good.
At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets.
So, developed world equities, oil and industrial commodities, emerging markets, and commodity-related currencies like the Australian dollar are weakening as risk aversion drives investors to the perceived safe havens of government bonds, gold, and Swiss francs.
It is all reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets.
As to what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.
- Remember that markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor's of the US government's credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.
- Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that's another way of saying expected returns are higher. And while the media headlines proclaim that "investors are dumping stocks," remember someone is buying them. Those people are often the long-term investors.
- Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive months of gains totaling almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.
- Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road.
- Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. As the IMF noted recently, while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving.1 A globally diversified portfolio takes account of these shifts.
- Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.