Tag Archives: Stock Market Volatility

Lessons From Thanksgiving Dinner

Talking to friends and family at Thanksgiving dinner made me realize how unprepared for volatility investors are. The gathering I attended was filled with a wide mix of investors, from the young and novice interested in technology stocks and (somehow still) in Bitcoin to older, seasoned veterans. The veterans, however, didn’t exhibit much more savvy than the novices; everyone was spooked by the recent volatility.

Based on my Thanksgiving Dinner experience, here’s what I think investors need to learn now.

Re-Set Your Expectations

First, I think investors are spooked because they are being unduly influenced by the market action of 2017. But that was an unusually calm year that saw a 22% gain in the S&P 500 without a down month. That’s a Bernie Madoff-like performance — straight up every month like clockwork with no hiccup to the downside. That kind of performance usually only occurs when someone makes it up. Investors should realize that 2017 is an anomaly and that volatility is part of investing. Financial markets are rarely that smooth and stable. Do your best to expunge 2017 from your memory.

Below is a monthly chart of how the S&P 500 Index performed in 2017 and for the first 10 months of 2018. It may surprise you to see that the index was still in positive territory at the end of October. A $100 investment in the index at the start of the year was still worth more than $102 on Halloween. As of this writing (Nov. 23), the index was still in positive territory, albeit barely ((0.19% for the year, including dividends).

I don’t point out that the market is still positive to give investors encouragement to take more risk though, or to argue that markets have delivered solid returns this year. I do so in order to impress on you that large cap U.S. stocks are still positive, and that your sense of markets might be warped. This year feels awful to investors, but the returns really haven’t been bad. There’s a disconnect between the year’s returns and what the year has felt like. That’s because 2017 was so strange in the index posting positive gains for every month.

Reconsider Your Allocation

I also don’t mean to encourage investors to think they can time markets perfectly. The point is not to dance in and out of stocks adroitly, missing losses and capturing gains; it’s having an allocation that gives you enough of the upside and allows you to live with the downside without shaking you out of your investments. If the recent volatility makes you want to sell, chances are you have too much stock exposure, or you have to re-calibrate your expectations from financial markets.

I think most investors I meet with have more stock exposure than they can handle. Or at least they strike me as being badly prepared for declines either because they don’t have advisors or because they have incompetent advisors who don’t disclose risks and historical volatility. When declines come, many of them will bail out at or near the bottom despite the fact that Morningstar’s most recent “investor return” numbers suggest investors are getting better at mistiming markets. Instead of falling into that trap you should reassess your allocation now, before any damage has occurred. That’s not a prediction that a crushing decline is around the corner; I wish I could be that clairvoyant. But you should always be prepared for one. And you should have an allocation that encourages you to buy after a big market decline, not sell.

Hold Extra Cash, But Avoid Bunker Mode

Having just given all those warnings about market timing, I still think it’s fine to hold some extra cash. Every reasonable market valuation metric, including the Shiller PE and Tobin’s Q, is flashing expensive. None of these indicators are good at forecasting short term market moves; markets can get (and have been) more expensive. But they are good are forecasting the next decade’s worth of returns. Returns will likely be low from current valuations. That means holding some extra cash is warranted. But, for goodness sake, don’t go to 100% cash with long term assets, thinking you’ll time your reentry perfectly. The paradox of sidestepping a decline is that if the market crashes, there’s a good chance that you’ll feel so good for having missed the decline that you’ll have a lot of trouble getting back in. But 10% or even 20% more cash or shorter term U.S. Treasuries than usual for long term assets isn’t unreasonable either.

Rules For Managing Volatility

Volatility is back. Your success as an investor is based on how you’ll deal with it. Here are some rules to help you cope.

First, reconsider your allocation. If you have 50% or 60% stock exposure in what’s often called a ‘balanced” portfolio, and you can’t handle a 5% or 10% portfolio hiccup, you’re probably in the wrong allocation. After all, a correction (stock market decline of 10%) will take your portfolio down around 5% and a bear market (stock market decline of 20% or more) will take your portfolio down 10% or more.

In 2008, balanced portfolios dropped around 20%, and that’s what I tell balanced portfolio investors to anticipate. We’ve had two 50% drawdowns in the stock market since 2000, and there’s no reason why we can’t have another one. It’s true, we may not. But we just as easily might. Now is a good time to do a gut check or reconsider your allocation.

It’s possible that you can handle more volatility, but are just unaccustomed to it right now, so it feels particularly bad. Think about what it will be like to see your portfolio down 20% or 25%. And put a dollar value on that. Most people don’t think of their money in terms of percentages. That will help you figure out if you’re reasonably allocated or not.

Second, don’t be ashamed to admit you can only handle so much volatility. Financial planners are always pushing clients to invest more in stocks. But I think they do their clients a disservice because the advisors are neglecting to consider carefully whether the clients can handle the volatility of owning stocks. Sure, planners give clients risk questionnaires. But those only go so far. Nobody really knows hows they’ll react to stress until it arrives.

Also, advisors are human, and they probably have a more attractive view of themselves and their skills than they should. That means they think they’ll be able to soothe you better than they probably will when the market goes down. Advisors like to think that they can soothe clients, but if the client wants to leave, the advisor will do what the client says rather than lose the client. So don’t let an advisor push you into more stock exposure than you can handle. The best advisors work hard to find out what the best allocation is for you; they don’t try to push you into an allocation or make you feel badly for not having more stock exposure.

Third, if you have to sell, don’t get all out of stocks with your long term money. It’s a mistake to sell everything, even if you think the market will keep going down, and it does. That’s because it will be harder to get back in. You won’t know where the bottom is (nobody ever does), and you’ll be too scared to dribble money in if you’re all out.

If you maintain some modicum of stock exposure, you’ll at least have that capturing gains when the market delivers them again. But you might be wrong about when the market will turn, so keep 25% of stock exposure as a hedge against your inability to call at bottom — or act after prices drop a lot.

Investment legend Benjamin Graham said “enterprising investors,” those who study the markets and investments carefully, can toggle between 25% and 75% stock exposure, but no more and no less on either end. You might want your bands to be more narrow depending on your age, etc… Try toggling between 60% and 30%.

Personally, I think valuations are insane, but I have for a long time. And the market just keeps running. That doesn’t mean I may not be correct eventually, but eventually can be a very long time. Have some humility. You need it in this game.

Fourth, don’t assume changing your allocation is easy . If you go down to 25% or 30% stock exposure, but that’s not really optimal for you, it may be hard to get back in. That’s because the criteria you might wait for – a cheap P/E ratio or some technical indicator – may never materialize or stick around long enough for you to act.

Fifth, even if you do get an opportunity, remember there’s never a time when “the coast is clear.” Whenever stocks drop a lot, it feels bad to buy them, even if that’s what you should be doing. That’s why having a system is so important. Simply responding to market moves in an ad hoc manner probably won’t go well.

Sixth, see an advisor if you can’t settle non an asset allocation or handle market moves well.

Learning Emotional Control From This Year’s Market Moves

Labor Day Weekend has ended, and the year is two-thirds over That means it’s a good time to assess what has happened and where we stand in the markets. It’s also a good time to remember what you might have been feeling earlier in the year when asset classes were behaving differently.  Understanding your emotions is a big part of successful investing, and can help you deal with market volatility in the future.

US Stocks In 2008 – Up, Down, and Up

The S&P 500 Index ended August up 9.94% for the year. But that seemingly happy statistic doesn’t indicate what an investor might have felt at various points during the year. After a blistering January during the first three weeks of which it gained nearly 10%, the market melted down in February and March during which it gave back the January gains.

It’s hard to remember now, but many investors were euphoric in January and terrified in March. If you examine our phone logs, they will bear that out. We always get more calls from clients and prospective clients when things look difficult, and our phones were silent in January and ringing non-stop in March. My colleague Danny Ratliff and I also fielded a memorable call on our radio show from an investor in his mid-50s with a balanced allocation whose portfolio was down 5% from its peak. This person was unnerved by that decline, but it didn’t occur to him that he should expect that routinely from a balanced portfolio.


The first lesson investors can learn from this year’s market moves is that short term (say, month-to-month) forecasting is virtually impossible. Don’t even try it. We try to manage risk as much as any advisory firm, but no advisor can deliver all of the market’s upside and none of its downside or time every wiggle and squiggle in all asset classes. Some of the burden of achieving good returns falls on you and your ability to control your behavior and to be realistic about volatility.

The person who called in to our radio show probably wasn’t just upset by the 5% decline in his portfolio, but also by the prospect that the declines would continue. And he was right to be thinking about that. Investors should always contemplate a 50% stock market drawdown because that’s how big the last two stock market drawdowns were. That implies a loss in a balanced portfolio on the order of 25%. Accepting volatility is the price of admission to the financial markets. the good news is you can choose how much to accept. Nobody is forcing you to have a lot of stock exposure.

The second obvious lesson is not to get lulled into a false sense of security. The market’s blistering run in January – after a nearly 22% gain in 2017 when the S&P 500 Index experienced no down months – caused investors to be shocked by the February-March declines. But it shouldn’t have. A run like that should have made you suspicious and girded you for volatility. Now that the markets have been calm again through the summer, you should be prepared for volatility again. Nobody knows for sure when it will arrive; the calm may continue for a while longer. But after such calm you’d be foolish to be surprised by turbulence. Stop getting fooled by the same things, and by thinking markets will calm down once and for all at some point. They never calm down once and for all. The calmer they are, and the longer the calm lasts, the more suspicious you should be. You should think that the next big decline is always at hand — and that’s because, often enough, it is. That’s just the way markets work.

The third lesson is to have an asset allocation you can live with. Don’t count on any risk management system to save all your bacon all the time. Investing means taking periodic losses – at least on paper. Get used to it. It’s part of the game. If you’re near retirement or in retirement, and you can’t tolerate losses, there’s nothing to be ashamed of about that. Get yourself into an allocation that will inflict less volatility on you. Reduce your stock exposure for goodness sake. The right amount of stock exposure is the amount you can live with and that will not cause you to sell if the stock market goes down by half. If you’re tempted to sell during declines, you have too much stock exposure. Take this opportunity to think hard about your allocation, and whether it will cause you to do something stupid like sell hard into a decline.

The Case of REITs

REITs have also had a year of distinctly opposite moves. Unlike the rest of the stock market which roared in January, REITs opened the year poorly. They dropped around 10% in January and February on interest rate fears. REITs are required to pay 90% of their net income as dividends, which gives them some bond-like qualities. That means when rates rise REITs can go down, even if they are the stocks of companies that can pass inflation costs on to tenants in the form of higher rents eventually.

After their 10% drop, REITs began to rebound in late February, and they haven’t looked back since. They are now up around 5% for the year or more than 15% from their lows. But the lessons are the same as with the broader stock market’s moves this year. Don’t try to time every wiggle and squiggle. And now that REITs have put together a strong run, be more suspicious than excited about them. Last, get exposure to them that you can tolerate. Chances are, you won’t time big moves into and out of them well. Make an appointment with us if you need help identifying a reasonable asset allocation.

Why We Trumpet Our Worry

Many clients and prospects who meet with us ask why we’re so pessimistic. There are a couple of reasons. First, although we don’t set out trying to be pessimistic, we report economic numbers and security valuations the way we see them. Bonds are giving poor yields, and stocks are at nosebleed valuations on any reasonable metric — Price/Sales, Shiller PE, etc… Consumer debt is high, as the middle class tries to maintain it standard of living on stagnating wages by borrowing. Economic growth since the last recession has been tepid. There’s no way to sugar-coat that, so we don’t try. We owe our clients our honest opinions.

The other answer has to do with managing investors’ behavior. We have a lot of collective experience in the financial services business, and we’ve seen investors make a lot of mistakes. And, yes, we’ve made a few ourselves, because we’re not perfect. Undoubtedly, we’ll make more. But our experience tells us that investors sell at bottoms. Everyone in our business knows this is a classic problem. Morningstar investor returns data often show that there is a 2 percentage point gap between mutual fund returns and the returns fund investors capture, though the last report Morningstar issued on this subject was admittedly more hopeful. If we are pessimistic it’s because we are trying to let investors know the stock market usually provides a bumpy ride, and tests your patience. It delivers gut-wrenching declines at times, and we prefer to see investors not sell during those declines. In fact, we want to prepare our clients so well for declines that they have a bias towards buying stocks when markets swoon.

All advisers want what we want; we are not unique in wanting to see our clients not sell at the bottom. The question, then, is how to combat the inherent urge to sell at the bottom. One possible tactic is to inculcate a buy-and-hold mentality in investors, and that’s a reasonable approach. But, although it doesn’t have to entail this, that approach often glosses over how painful declines can be, or just counsels investors to fight through them. That’s likely what investors should do, but telling them to grit their teeth may not be the best strategy to get them to do that. The buy-and-hold message emphasizes that investors usually come out better on the other side of a big market decline at the expense of focusing investors’ attention on how they might feel during the decline when they are likely to do the most damage to themselves.

We’d rather focus investors’ attention on how they might feel during the depths of a decline, and say to them,

The last two market declines have consisted in 50% drawdowns, so forget about the market’s long-term 18% standard deviation. You will be inclined to behave badly when you see your portfolio value declining, if you don’t think hard about that moment now when you’re more calm. You will want to sell everything to stop the losses instead of buying at cheap prices. And that will lock in your losses and potentially cause you to miss the eventual upswing. You will likely do yourself permanent damage. You will focus on how much your account has declined instead of focusing on how cheap stocks might be at that moment, and if you get too much stock exposure now you will not be inclined to buy at that moment. You will want to fire us as advisers, and you will never want to invest in stocks again. Or you will find an unrealistic and/or unscrupulous adviser who will tell you they can deliver all the market upside with none of the downside.

Try to remember how you felt and behaved in 2008-9, and then consider how much stock exposure you really want to have. We will do our best to manage your downside, but much of your success depends on your choosing an appropriate amount of stock exposure to begin with. That amount is usually less than you think it is, especially after a 9-year bull market.”

We think saying these things, and working hard to assess a new client’s risk tolerance, are more effective than emphasizing coming out on the other side of a bear market. Coming out on the other side isn’t the problem; the decline is the problem. Investors can’t see their way to coming out on the other end in the middle of a bear market, and encouraging them to do that at that moment isn’t helpful. We’d rather address bad behavior at a moment when investors — especially retirees, who are most vulnerable to fluctuating account — are in a better psychological state to listen.

We encourage investors to access the fear they’ve felt during past declines, before the next one ensues, and we never shame them into owning more stocks than they can handle. We think a lot of advisers subtly shame investors into owning more stocks because of how stocks have performed over the last century or so relative to bonds. Much of these gains owe to a price multiple expansion that was likely a one-time event during the 1908s and 1990s, as Rob Arnott and Peter Berstein have argued. And there are long periods when stocks have delivered poor returns.

No adviser knows exactly when bottoms and tops occur, but an adviser with experience can often judge the psychological temperature of clients well. An experienced adviser can often surmise how clients will react under different market conditions better than clients themselves. Clients are notoriously poor judges of how they will behave under adverse market conditions. They tend to block out how they felt in 2008, for example. And they are poor judges of how much stock exposure they can handle.

Clients will have to assess for themselves which approach and which kind of adviser will help them withstand market volatility, and help them buy — or at least not sell — into steep declines. The buy-and-hold approach, after all, is really a buy-and-rebalance approach, and investors adhering to it must rebalance in down market by purchasing stocks.

We are grateful to the clients who have entrusted us with the management of their capital, and we look forward to meeting new ones who seek an alternative approach. Click here to schedule an appointment with us if you are interested in hearing about our approach to asset management and financial planning.

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.”