Market at new highs. Is volatility lurking around the corner?

Market at new highs. Is volatility lurking around the corner?

May 11, 2021

The stock market continues to make new highs and valuations are stretching above their historic norms. This fact is astonishing as we are still emerging from a global pandemic and the recession and lockdowns are fresh on investors’ minds. That being said, GDP growth is accelerating, consumer spending is quite strong and the Federal Reserve continues to be expansionary, keeping interest rates at historic lows. Given our experience from just a year ago, many may feel like more volatility could be lurking right around the corner. Of course, we’d all like to avoid market declines, yet no one can predict with any accuracy when those will occur. However, expecting dips in the coming months and years is likely a safe bet. It is important to be mindful about how to deal with portfolio volatility. As a swift change of course could have a catastrophic effect on your longer-term investing success. Remembering these simple principles should help smooth out the ride.

Remember, volatility is normal.

Volatility in the stock market is very normal. And feeling uneasy about a lower portfolio value because of volatility is a normal part of human nature. Over the past eight decades, investors have experienced moderate pullbacks of 5% roughly once a quarter on average. Even in years with outstanding equity returns, there are bouts of volatility. The chart below shows the annual returns and intra-year drops over the past 40 years. What we cannot show in the below chart is the seasickness an investor feels while riding these waves of volatility to temporarily lower portfolio values. Focusing on the long-term trends of the market rather than the short-term gyrations should give investors the confidence to ride these waves. Because, on average, the stock market has generated a positive annual return more than 70% of the time in the past 40 plus years.

Source: J.P Morgan Asset Management. As of 3/31/2021

Stay the course.

Frequent dips in the market can be unsettling, and can encourage market timing, but investors should not jump ship. Being fully invested is particularly important when there is market volatility, because the best and the worst days in the market tend to be clustered together. If you were lucky enough to miss the worst days, you also were very likely to have missed the best days.

The chart below illustrates the impact on investment performance of being out of the market on the very best days over 20 years. An investor who didn’t jump out of the market and stayed in a fully invested portfolio would have returned nearly double a person that missed the 10 best days in the market. Additionally, as the majority of the best days occur within two weeks of the 10 worst days in the market, it is likely that investors who sold equity because of seasickness after a bad day often also missed a big rebound. Staying the course through bouts of volatility can have big payoffs.

Source: JP Morgan Asset Management

Diversification eases the bumps.

Portfolio stability can be managed through effective diversification. Although economists have a positive outlook on the U.S. for the coming year, other international market's equities can give your portfolio both exposure to growth and risk factors outside the U.S. economy that may help boost returns and lessen the dips. While a combination of various asset classes should improve portfolio returns, diversification is most valuable for keeping a portfolio on an even keel.

Diversification has been shown to improve the risk/return profile of an asset allocation portfolio relative to just U.S. equities over the past 20 years. This means investors in a diversified portfolio sailed through market volatility feeling fewer waves. The reason why is that differing investments zig and zag at different times. This combination of investing in different asset classes tends to work well to smooth the bumps.

This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.