The Oxford dictionary defines volatility as the liability to change rapidly and unpredictably, especially for the worse. When we are saving for retirement or relying on our retirement earnings after many years of hard work, this word sounds terrifying. What a terrible idea. Who wants their investment return to change rapidly, unpredictably for the worse? No one. So why do millions of investors tolerate the volatility of the returns in the stock market? The answer lies in the risk return trade off. The more variable an asset’s return, the riskier the asset, the greater the return investors demand from that asset. Whereas investments with no risk offer a small return.
The average annual return on the One-Month Treasury Bill - typically considered a risk-free investment, from 1997 – 2016 was 2.1%. During that 20-year period, investors in T-bills never had a loss, although there were periods after the great recession when returns were zero. Inflation over the same period was 2.1%, leaving investors in One-Month US Treasury Bills with a return after inflation, or real return, of 0% annually over the 20-year period.
Compare that to the popular, but volatile, S&P 500 Index over the same 20-year period. By contrast, the S&P 500 produced annual losses in four out of those twenty years - the greatest being a whopping loss of 37% in 2008. So why would an investor take such risks? Because over the same period the average annual return on the S&P 500 was 7.7% or 5.6% after inflation, providing investors with meaningful real return.
Most investors are only concerned with downside risk, or the prospect of a loss. (I’ve never heard of someone complaining that their upside return was too great.) In fact, historical data tells us that the US market has been negative approximately 25% of the time, or 23 of the last 91 years, from 1926 to 2016 (see chart below). Still, during this longer period, investors were provided with meaningful real return for the risk taken. Per the Center for Research in Security Prices at the University of Chicago, the US Market provided an average annual return of 9.8% from 1926 to 2016, or 6.9% after inflation (2.9% inflation data provided by Morningstar).
When money is invested for the long term, and the investor doesn’t overreact to negative years, the returns are substantially greater. Investing in the equity market will be volatile. No one can accurately predict if a year will be positive or negative, but over history, that volatility has been rewarded by greater return.
Recent market performance, dubbed the “Trump rally,” has given investors pause over concerns about the market hitting new highs and where it will go from here. As years of investment data supports, attempting to predict the direction of the market over long periods of time with any accuracy is a near impossibility, and one which extraordinarily few have been successful at over the long-term. Warren Buffet recently demonstrated this by his declaration of victory on his 2007 bet that an S&P 500 index fund would beat a pool of hedge funds over the following 10 year period. With one year remaining, the simple index fund gained a cumulative 85% for nine years, while the pool of hedge funds averaged a cumulative gain of 22% over the nine year period.
Since the identity of the hedge funds in the pool have not been publicly released, it is impossible to know what went awry for these actively managed funds. We believe the underlying data will support two issues – the excessive fees charged by hedge funds and their attempt to guess the direction of the market or particular stocks. Hedge funds, by their nature, are designed to hedge against perceived market risks and perils – which are rarely in short supply.
While the U.S. is in the 3rd longest economic expansion in history, it has been a remarkably slow expansion. The economy continues to strengthen, but has been largely dependent on the stimulus provided by the Fed. The more recent market run-up reflects investor expectation on infrastructure spending, deregulation, and tax cuts. Concerns about rising interest rates, tariff wars, and the economic impact of immigration remain at the fringe, for now. Civilian unemployment (seasonally adjusted) is at 4.8% in Jan 2017 down from 10% in Oct 2009 and below the 50 year average of 6.2%. However, wage growth remains stagnant at 2.4% vs. 4.2% for the 50 year average. **
This begs the question, what is an investor to do as the markets reach all-time highs? The simple answer is to remain focused on the long-term and ignore short-term market noise, remain diversified, rebalance the portfolio on a consistent basis to maintain your asset allocation and take advantage of sector underperformance (currently the international developed markets and the emerging markets have lower valuations), and preserve the tax efficiency of the portfolio. Looking at the graph below, imagine the investment return if an individual pulled out of the market every time it hit a new high. They would be out of the market on a fairly continual basis. The markets continue to perform as the global economy grows and business profits increase.
Of course, there is no guarantee we won’t see a correction in the coming year(s). Just a year ago, the markets faltered on concerns about a Chinese hard landing – which still hasn’t come to fruition. But at this point, we aren’t seeing the frothy valuations indicative of insanity. The S&P 500 forward P/E, as of March 1st, is 17.5, roughly 13% above the 100-year-average of 15.
Still, pundits and forecasters, more concerned with attention-grabbing headlines than reasonable commentary, will use the higher valuations to peddle fear of the next market crash. So, let us not soon forget these words of wisdom from Warren Buffet in his 1980 letter to shareholders of Berkshire Hathaway Inc: “forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”
**Data provided by JP Morgan