Volatility And Its Role in Financial Returns
What a difference a month makes ! The stock market in December (2018), as measured by the S&P500, declined 9%; the stock market in January (2019) gained 8%. Now that’s some kind of volatility! As we mentioned in previous commentaries, there were both fundamental and technical issues that generated this volatility. Quick review, the primary fundamental issues were: concerns over the trade dispute with China; concerns that the Federal Reserve was out of touch with economic reality (i.e. would go too far in raising interest rates); and concerns over global economic and corporate earnings growth. The primary technical factor affecting volatility was program (or algorithmic) trading which now accounts for up to 75% of average daily volume in the stock market. Program trading is not fundamental or fundamentally driven, but it can and does have a material short term impact on volatility.
So where are we now? In January, a number of positive things occurred: early in the month, a couple of influential Federal Reserve Board members were commenting that the Fed’s stance on rates may be too draconian; a number of large companies reported better than expected profits; and later in the month following the FOMC meeting, Fed chief Jerome Powell made comments to the effect that the Fed was materially backpedaling on its 2019 interest rate policy. This provided relief to investors who were concerned the Fed was at risk of going too far in raising rates (which it was, in our opinion). This plus scuttlebutt mid-month that trade discussions with China would/could lead to a positive outcome were enough to generate a strong rally in January. As of now, we are relatively sanguine on the stock market outlook and believe the underlying fundamentals still support higher stock prices this year. We believe the biggest near-term risk is the trade deal with China. We think the risk of a recession in 2019 is low.
But what about volatility? Certainly downside volatility like we experienced in Q4 is not pleasant. But volatility is an important component of generating higher investment returns. As investors, we have to stomach occasional periods of volatility in order to generate higher returns. If we want zero volatility in our portfolios, we can expect essentially zero or very low returns. In support of this idea, Financial Planning magazine recently ran an interesting article entitled “You Can’t Win If You Are Afraid To Lose”. The article looked at the performance of 2500 mutual funds between 1998 and 2017 in order to analyze how volatility affected returns. The article’s findings support the idea that a) higher risk (volatilty) is positively correlated with higher return; and b) the best performing portfolios experienced negative returns (down years) 25-30% of the time, or roughly 4 or 5 years out of the 20. What does this mean for us as investors? Primarily, we need to be willing to stomach occasional (downside) volatility to generate higher long-term returns. We would also add that a diversified approach to investing, such as we do here at SRS, we believe is the best way to generate higher returns with lower risk. While the inevitable periods of volatility can make us feel upset, as long we take a long-term view towards investing, avoid market timing, and invest in quality diversified portfolios, we should have a greater probability of achieving higher portfolio returns over time.
Robert Toomey, CFA/CFP
Vice President, Research