Volatility Is Back
After a bad week in early February when the S&P 500 Index dropped 10% to meet acknowledged definition of a correction, the market has rebounded and investors have mostly regained confidence. On Monday, March 5, the Index bounced over 1% higher making its year-to-date return over 2% — a perfectly respectable return in the early days of March.
However, one can’t help but have an uneasy feeling that it’s a different market environment in 2018 than it was in 2017 when, for the first time in history in one calendar year, the market posted positive gains in every month. Using the S&P 500 Price Index (not including dividends), The market was so anesthetized in 2017 that it posted only 8 days of gains greater than 1% or losses more severe than -1% from the previous day’s close. This year, the market has already posted 16 days of gains greater than 1% or losses more severe than -1% from the previous day’s close.
Moreover, the index experienced no one-day 2% gains or losses in 2017. It has already had three such days in 2018, all of them to the downside.
Another way to look at volatility is to measure the average daily volatility, using absolute value of daily changes. As our chart shows, over the roughly five year period from the start of 2013 through March 5, 2018, the S&P 500 Price Index moved an average of 0.54% on a daily basis. For 2017, that number shrank to 0.30%.
It’s also useful to look at standard deviation, a statistical measure that indicates the range of most, though not all, moves from an average. For the five year period, the standard deviation of the index was 0.77%, while for 2017 the standard deviation was 0.42%.
Lessons for Investors
Investors should learn from this graph that the low volatility of 2017 was unusual and that it’s not reasonable to expect that environment to persist. Investors should also take the opportunity to review their asset allocations. The fact that markets have rebounded since their declines in early February shouldn’t be so much cause for joy as an opportunity to reassess how much volatility is tolerable.
If an investor was unnerved by the market drop in early February, that likely means their allocation was inappropriate. Too many investors have piled into stocks because bond yields are low and long-term historical stock returns promise to make up the difference for under-saving for retirement. But century-long or longer stock returns mask the fact that stocks go through decade-long and two decade-long fallow periods, especially when valuations are as high as they are now.
Investors tend to forget how they feel during bear markets, especially when those bear markets are in the distant pass. We tend to have what behavioral finance professors call an “empathy gap” regarding our own feelings and behavior in stressful markets. But since early February isn’t that far away, investors should use it as an opportunity to reassess how a downturn might make them feel. If you wanted to sell stocks instead of stay put or buy them as prices got cheaper, it’s time to reassess your allocation – while you still can without having to change it after a decline.
Investors should also consider that bonds, though offering lower than normal historical yields, still have a place in portfolios. Their stabilizing influence is often most welcome when investors have written them off as boring next to stocks, their more exciting cousins. As other investors forget risk and unnerve their brokers and advisors with extreme bullishness, it might be a good time to be cognizant of just how much excitement you can tolerate. Investors feeling themselves capable of accepting more risk should also consider the words of investor Howard Marks, — “The truth is, risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so, and risk compensation will disappear.”