Addressing the #1 concern people have about investing

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Investing Smart: Stock Market Volatility

There are many excuses people use to avoid investing in the stock market. “The international situation might cause a crash”, “The market is really high now and will probably go down soon”, “The market has been heading down lately”, “I’ve heard the advice to ‘sell in May’ so I’m out of stocks for the summer” – and many other reasons.

To be concerned with some of these points – especially as much as the financial media loves to talk about the most recent drama – is normal. It’s good to be aware of what is going on around the world, and to at least consider the opinion of some professionals. But it generally isn’t a good idea to base your investing behavior on these opinions or news stories. Financial advisor and industry expert Tim Maurer recommends people “exercise deliberate indifference” – meaning notice the news but don’t act on it.

Here’s a secret

Well, it really isn’t a secret at all. The stock market goes up, and it goes down, then it tends to go back up, then it tends to go back down, then up – over and over again. This fact is what people are talking about when they mention market volatility. Volatility just means that the market varies day to day, week to week, and year to year. It means that the stock market will go up sometimes and down sometimes.

Guess what though – through inception, over approximately 150 years, the S&P 500 index*  has averaged about a 10% annual positive return. That is in spite of the fact that there have been more than one hundred twenty “market corrections” (drops of 10% or more) in that same timeframe. Yes, that is an average of a correction every 2-3 years.  (*The S&P 500 index tracks 500 of the largest publicly-traded American companies)

So volatility, or variability, is normal. It is to be expected and – if you are still actively building your investment portfolio – it can even be a very good thing. To see how this might work to your favor check out our post explaining Dollar Cost Average investing.

Let’s look at a few of those excuses mentioned earlier

“The international situation might cause a crash”

It’s true that international events can cause the stock market to drop. Just look at the BREXIT example from June of 2016. The S&P 500 index dropped 5% in just a couple of days, and some people in the news were saying it was going to drop a lot more. It could have dropped more, but it didn’t. In fact it has already recovered from that drop and is in fact about 4% higher than it was just before the BREXIT situation.

“The market is really high now and will probably head down soon”

That’s very possible, but remember that volatility is expected and over the long term the stock market has positive returns of almost ten percent. Here’s an extreme example to show this point. Remember the start of 2008 with the housing bubble and stock market at all-time highs? The S&P index dropped almost 57% over the following year or so. It was scary! But here’s the thing many people don’t consider: If you put money in the market at it’s peak in 2008 and left it alone through that correction and rebound, that money would be worth about 50% more now (in mid-2016). So it not only recovered from the loss, but it continued to set new highs – as expected by people who study long-term investing.

“The market has been heading down lately”

Since the market goes up and down, but averages to the upside over a long period of time, a downtrend can be a good buying opportunity for someone who is still building their investment portfolio. If you haven’t already, read our post on Dollar Cost Average (DCA) investing. A DCA investor buys more shares while they are on sale – just by holding steady with their investment philosophy.

“I’ve heard the advice to ‘sell in May’ so I’m out of stocks for the summer”

I’ve heard this too. If enough people believe that it can become self-fulfilling. A whole bunch of people selling is what causes stock prices to go lower. But if you sold at the beginning of May 2016, you missed out on the 4% gain that has occurred so far through the middle of July. Yes, the market will continue to go up and down – that’s the point – but this “rule” doesn’t always hold true and isn’t a good investing practice.

Do you want to know the best time to trade on the latest news?

Never. That’s when. Develop an investing policy for yourself (even financial advisors are required to do this) and stick to it. Follow that policy regardless of the latest news or your nerves or advice from your uncle. Spend some time really thinking about what you believe about investing and the stock market and write it down; then follow your own advice.

How do you lower volatility?

There are some ways you can lower volatility, like adding more bonds to your portfolio, but anything done to lower volatility almost always lowers long-term average returns. If you want to get fancy, a really good investment advisor should be able to help you structure a portfolio mix that still has volatility, but has a variety of investments that are inversely related. By that I mean multiple investments that historically move in the opposite direction. So there will still be volatility, but some of those movements will counter-balance others, meaning the overall portfolio should fluctuate a bit less than an S&P 500 index.

What you should be thinking of instead is to protect yourself from the volatility. Embrace the volatility as as normal occurrence, but position yourself so it doesn’t matter. If you are still putting money into your investments, volatility shouldn’t matter much to you – in fact you should like it. Do make sure you have an emergency fund though so you don’t get into a position where you need to sell some stocks (while the market might be down) to cover an unexpected expense.

When you get closer to, or actually in, retirement then you should have an even larger emergency fund. Really at this point we tend to just call this a cash reserve. I’ve heard financial advisors mention between 18 and 24 months’ worth of living expenses. The average correction tends to last eighteen months or less (see the 2008/9 example) so having a large cash reserve in retirement means you can draw down the cash without having to sell investments while the market is low. Then as the market recovers you rebuild the cash reserves. This helps retired people tolerate market fluctuations without worrying about being forced to sell at inopportune times.

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