The stock market is back to its volatile ways, swinging up and down with startling frequency. It’s enough to make you lose faith in the stock market and stash your cash in the mattress.
Don’t. We’ve seen this before, and much worse. How’s this: On October 1987, stocks fell 22 percent in one day! That one day marked the closing low for that “bear market.” After that, stocks bounced up and down for a few months and then rose to record highs within two years. More recently, on May 6, 2010, stocks fell 9 percent during the day and rallied to close down 3 percent (still a substantial loss). In less than one week, stocks were already trading at higher prices than before the crash. By November, stocks reached record highs. Of course, there have been more “flash crashes” and the scenarios tend to be fairly similar. Stocks fall sharply on one day, rise and fall violently for several weeks, and then resume their previous uptrend.
No question, this extraordinary volatility can be unnerving. Some investors become despondent and sell. As a result, many investors drastically underperform the indexes, as well as the very funds in which they are invested. Over the past 10 years, Dalbar, an independent research service, notes that the “average blended equity & fixed income investor” received a 2.6 percent total return compared with 7.4 percent for the S&P 500 Index and 4.6 percent for the Barclays Aggregate Bond Index. Dalbar blames investors’ poor performance on the propensity to get caught up with emotion, causing them to buy high and sell low.
There’s another way to view downturns.
Long Term Investing Generates Consistent Returns
If you look at the stock market as a long-term investment, the volatility may not be so unnerving. An investor with a typical balanced portfolio, say 60 percent stocks and 40 percent bonds (60/40), has experienced steady growth over the long term. Let’s look at rolling five-year periods. Since 1950, a 60/40 portfolio has had a median total return of approximately 10 percent, with no losing five-year periods. The last time a 60/40 portfolio had a five-year period loss was in 1941, a time that included the aftermath of the Great Depression.
Rolling ten-year periods have even more consistent returns. Even if you invested in 1927, right before the Great Depression, a 60/40 portfolio would have generated a total annual return of nearly 8 percent over the next 10 years. Of course, you would have had substantial losses in the interim period, but your long-term result would have been very positive.
In general, the longer the period, the greater the consistency. Over long periods of time, sharp plunges tend to appear as meaningless blips. Since 1926, there have been no losing 20-year rolling periods for the S&P 500. Not a one, even when including the Depression. During those years, the worst 20-year period for a portfolio invested 100 percent in the S&P 500 was about 3 percent. For a 60/40 portfolio, the worst 20-year total return since 1926 has been approximately 4 percent. The median total return for a 60/40 portfolio over a 20-year period since 1926 is about 9.5 percent. As you can see, a long-term approach often generates consistent, positive returns.
Volatility Creates Opportunity
With a long-term approach, you can take a different view of volatility. For smart investors, volatility creates opportunity. Stocks essentially go on sale. Scoop up those bargains and hold for the long term. There are no sure things in the investment world, but aside from the Great Depression, history has shown that holding a balanced portfolio over the long term has generated consistent, solid returns most of the time.
Volatility also creates the opportunity to rebalance your portfolio to maintain your target asset allocation. When a strong advance pushes the equity portion of your portfolio significantly above its target allocation, trim it back. Conversely, when a major decline lowers your equity allocation substantially below its target, take advantage of low prices to restore the portfolio’s targets. In this way, you maintain a disciplined approach of buying low and selling high.
This is the essence of what I call Peace of Mind Investing. Over the long term, stocks tend to rise, roughly in line with the growth of corporate earnings. Sure, there are bear markets now and then, usually about one or two per decade. But with a balanced 60/40 portfolio, your account will generally recover in a couple of years, and then it’s usually on to another cycle of higher returns. It’s not exciting, but taking a long-term approach can help you generate the returns you need to achieve your financial plan and enjoy peace of mind.