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Market Volatility: A Normal Part of the Investment Process Thumbnail

Market Volatility: A Normal Part of the Investment Process

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May 19, 2022

It has been a rough start to 2022, and the last few days in the equity markets could have scared and confused even the most seasoned of investors. An example is when equity markets pulled back sharply on Wednesday, May 18th, leading to a new low for 2022. 

Volatility is a part of the investment experience, and equity market downturns are not uncommon, although uncomfortable. 

In my letter last week, I discussed the impact that inflation can have on the economy and the market. Other factors affecting equity markets include Fed actions to raise rates, increasing fears of a recession, continuing supply chain disruptions and the continuing conflict between Russia and Ukraine. 

The old saying "patience is a virtue" could be helpful for investors. Although it is easy (and tempting) to act emotionally, historically speaking, establishing a long-term financial plan and then staying the course and remaining invested can prove to be a wise decision in the long run.

Our strategy is to put together a financial plan that, over long periods of time, helps our clients achieve their goals. Our primary responsibility is to focus on our clients' goals with the understanding that when it comes to equity markets, it is nearly impossible to determine which singular day will produce the next high or low. 

Berkshire Hathaway recently held their annual investor day, during which Warren Buffett confessed, "We haven't the faintest idea what the stock market is gonna do when it opens on Monday — we never have." Later in the same session, he went on to say, "I don't think we've ever made a decision where either one of us [i.e., Charlie Munger] has either said or been thinking: 'We should buy or sell based on what the market is going to do.'"

We fully understand that the next few days, weeks, or months could bring more volatility. We are also confident that we have used our best efforts in creating portfolios for our clients. Please be comfortable knowing that we are aware that these are challenging times, and we believe an educated client is the best client. As always, we are available to revisit your financial holdings with you. 

Uncomfortable, but not Unusual.

Volatility, or more specifically drops in the financial markets, is a more common occurrence than you would think. The table below shows us just how often these downturns happen. 

I know you've heard this before from us, but it's worth repeating. We can't pinpoint a market bottom, and there is some evidence that periods of outperformance can follow periods of market disruption: 

  •  In the 32 times the S&P 500 Index has shed at least 10% since 1980 (excluding the current correction), one year after hitting the bottom, the index was up 24.8% on average. It was higher 90.3% of the time
  • In the 13 times the S&P 500 has dropped between 10% and 15% since 1980 (excluding the current correction), the average gain from the low after one year was 21.9%. The index rose in all but one of those instances after one year.

According to a JP Morgan analysis, even missing a few days of a market recovery can be costly. This analysis looked at the S&P 500 over a 20-year period (January 2000 to December 2019). Investors who stayed fully invested would have earned more than 6% annually. However, those investors who missed just ten of the days with the highest daily returns would have earned only 3% annually. During those 20 years, six out of the ten best days occurred within two weeks of one of the worst 10 days. 

A quick review of some market terms.

Oftentimes, we hear the wrong words used in the wrong context. For educational purposes, we feel it is important to clarify some stock market words and their definitions.

"Dip" -  a short-lived downturn from a sustained longer-term uptrend. Example: Equity markets increased by 5% and maintained that level and then dipped back down to 3%, all within a few days or weeks.

"Correction" -  a 10% drop in the market from recent highs. Historically corrections occur an average of about every eight to 12 months and last about 54 days. (thebalance.com 3/9/20) Example: On December 17th, 2018, both the DJIA and the S&P 500 dropped over 10%, and declines continued into early January. 

"Bear Market" - a long, sustained decline in the stock market. If the market declines 20% from its recent high, this is considered the start of a bear market. Example: On Wednesday, March 11th, 2020, The DJIA dropped 5.9%, for a total decline of 20.2% from a record high on February 12th, 2020.

"Crash" -  a sudden and dramatic drop in stock prices, often on a single day or week. Crashes are rare but typically happen after a long-term uptrend in the market. Example: In 1929, the market crashed when it lost 48% in less than two months, ushering in the Great Depression.

Context: YOU

Market declines happen, and therefore, no matter what equity markets are doing, your plan should align itself with these three items.

  1. Your investing goals
  2. Your financial timeline
  3. Your risk tolerance

Your Investing Goals

Every investor has unique goals they would like to attain. Knowing what your goals are is the first step to creating a path to achieve them. Your goals will determine your time horizon and risk tolerance.

Your Financial Timeline

Focus on your personal timeline instead of trying to time the market. During downturns, it may be tempting to pull out of the market, but you may miss out on a healthy recovery. Try to plan for your equity investments to maintain a long-term horizon and ignore the short-term fluctuations.

Remember, short-term movements of the market are unpredictable and do not abide by any average. For many long-term investors, there is no reason to even subject themselves to daily market headlines. If you have a long-term investment horizon for your equity holdings of at least five years, chances are the current volatility will pass - possibly in a couple of weeks, months, or at the most, a few years.

Your Risk Tolerance

Risk tolerance is the level of uncertainty you are willing to accept in order to reap potentially greater rewards. Knowing what your risk tolerance is or risk awareness should be part of your financial plan. As your financial professional, one of our primary goals is to help you create a plan that considers your risk tolerance. If you are not sure what your risk tolerance is, please call us, and we and help you assess and determine this for you. 

What should an investor do in a volatile market?

First, make sure you know what not to do - and that is panic. In times of market volatility, investors tend to become unnerved and anxious. This is not the best mindset to make rational decisions.

When equity markets experience unsettling fluctuations, we suggest you ask yourself three questions:

  1. Have my financial goals changed?
  2. Have my financial timelines changed?
  3. Has my risk tolerance changed?

If you can answer "YES" to any of these questions, we highly suggest that you discuss these changes with us. As an investor, you need a plan that includes risk awareness. One of our primary responsibilities as your financial advisor is to help you create a plan with risk awareness. We know that an integral part of this is to consistently keep in touch with you and monitor your situation.

If you have concerns, some questions to ask us may include:

  • Can we review my financial plan?
  • Can we revisit my risk tolerance?
  • Are my investments diversified?
  • Has the volatility presented any good opportunities?

Discuss any concerns with us!

We are always available to revisit your financial holdings to make sure they are still in line with your timeline goals and risk tolerance.

As a reminder, please keep us apprised of any changes, such as health issues or changes in your retirement goals. The more knowledge we have about your unique financial situation, the better equipped we will be to best advise you.

As always, thank you for the trust, confidence, and the opportunity to serve as your financial advisor.

Chris Duke
May 19, 2022