Advisor Blog

We frequently explain to clients that all investment portfolio designs are based on a set of tradeoffs.  Brad Steiman, Vice President at DFA, in his Northern Exposure article series does very good job of explaining one of the considerations in portfolio design in the following article.

Many aspects of life require careful consideration and balancing of the tradeoffs that arise from competing demands. For example, a common lifestyle tradeoff is working longer hours versus spending more time with your family. The competing demands within this decision are the income necessary to provide a suitable quality of life for your family versus the immeasurable benefits of quality time with your family. There is no right answer, but most people understand the tradeoff and attempt to find the balance that is right for them.

Successful investing and financial planning also require balancing tradeoffs. For example, a common investment tradeoff is that of risk and return. One of the competing demands is preservation of capital versus preservation of purchasing power. The former may allow for a better night's sleep during periods of heightened uncertainty and corresponding volatility, but the latter helps ensure you'll have a comfortable bed in the future when accounting for rising prices from inflation. Once again, there is no right answer, no "optimal" solution. Understanding the tradeoffs between preserving capital and preserving purchasing power will help investors find the balance that is right for them. This balance will depend on their definition of risk and attitude towards it.

According to a research report published by Vanguard, recent stock market volatility is not unexpected when compared to previous time periods of significant macroeconomic events.

"Although the stock market volatility... appears extraordinary relative to the calm of the last year, [data] demonstrates that the levels of market variations today are, in fact, "ordinary" relative to the volatility of other periods characterized by major gobal macro events." state authors Francis M. Kinniry Jr., CFA, Todd Schlanger and Christopher B. Philips, CFA.

From July 1992 to August 2011, the S&P 500 Index moved an average of 0.7% per day.  The daily volatility spiked - or doubled - to 1.46% when significant global events occurred.  "As a result, we would argue that... volatility in equities, although high and painful to many investors, was not unexpected, given the market environment and the widespread repricing of risk.  Thus, in Vanguard's view, to cast the current environment as a 'new paradigm' of volatility is misleading."

The Vanguard report found that from August 5 (the day that S&P downgraded US Treasury debt, kicking off this period of volatility) to August 30, the S&P 500 Index moved an average of 2.5% per day.  We examined the September and October time period and found that the average daily volatility was 1.6% and 1.5% respectively.  It is not unusual for volatility to spike and slowly decay (statistically, it is serially autocorrelated). 

In 2008, we saw 23 days when the S&P 500 moved more than 4%.  This level of volatility occurred for seven days in 2009, no days in 2010, and has occurred six times, so far, in 2011.  Movement of 1% happened on 129 days in 2008, 108 days in 2009, 67 days in 2010, and 59 days in 2011 to date.

The Vanguard report looked at the volatility of two hypothetical balanced stock/bond portfolios - an 80% S&P 500/20% Barclays Aggregate Bond and a 40% S&P 500/60% Barclays Aggregate Bond.  As expected, in 2008 and 2011, the S&P 500 experienced "markedly more volatility than the two more conservative portfolios." and concluded that investors with balanced, diversified portfolios have faced much less aggregate volatility than the headlines would suggest.  We concur.

Finally, the authors note that "realized volatility is a critical factor in the equity risk premium (ERP), or the extra return demanded by investors for investing in stocks instead of less risky assets such as bonds or cash" and that "periods of heightened volatility or risk can actually increase the forward ERP."  This is, of course, consistent with the message that risk and return in capital markets are inevitably related.

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 of months of gains totalling 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. 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.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.

World Economic Outlook, IMF, April 2011.

The First Law of Economics:  For every economist, there exists an equal and opposite economist.

The Second Law of Economics:  They're both wrong.

Disconnect, cognitive dissonance, in limbo.  I've heard all of those phrases used to describe the world economy - and, that's just today.  The Economist, in a recent article, points out that gold prices and the low yields on long-term treasury bonds point to opposite expectations for the economy - both inflation and deflation, respectively.  Perhaps this explains why you can turn on the television and hear a dozen conflicting pieces of advice within an hour.

One of our clients sent this photo, taken near his ranch, with the caption "this is what Obama is doing to our economy."  He also pointed out that the color of the bucket was even appropriate.  And, it's true that the cost of economic stimulus, healthcare reform, coming tax hikes, and more stringent financial regulation is worrisome.

The current direction of government policy (low fed funds rate, quantitative easing, huge deficits) certainly looks inflationary, but the economic fundamentals (slack in manufacturing capacity, sluggish growth, persistent high unemployment) look deflationary.  

Volatility in equity markets, which we've seen plenty of over the past quarter, is often viewed as being a measure of uncertainty.  Reducing policy uncertainty would encourage growth.  Uncertainty reduces the potency of stimulus because it encourages firms and consumers to hesitate and depresses spending and hiring activity.  Even incremental improvement in clarity may offer investors a chance to reassess the fundamentals that many analysts believe are still improving.

The US stock market has taken investors on a bumpy ride in recent years.  This volatility has tested investor discipline and prompted some people to question their commitment to equity investing.  While no one knows the future, looking at the past may help you gain a better view of long-term market performance and put the recent market volatility in perspective.

The above chart shows the historical distribution of US market returns since 1926.  The performance years are stacked in ascending order by return range.  This chart illustrates that:

• Market performance over the past two years has been extreme by historical standards.  In 2008, US stocks experienced their second-worst calendar return in eighty-four years.  Then, in 2009, stocks rebounded strongly to deliver a return in the top quartile of the historical distribution.
• Over the long term, the market's positive return years have outnumbered the negative return years.  Since 1926, the market has experienced a positive return in almost three-quarters of the calendar years.
• Not only are the positive years more numerous, the chart shows a larger concentration of performance in the higher ranges of returns.
• The sequence of calendar returns appears random, suggesting that accurately predicting future performance is a difficult, if not impossible, task for any investor or professional manager.

Over time, the market has rewarded investors who can bear the risk of stocks and stay committed through various periods of performance.