Why Stock Market Volatility Shouldn't Concern Long-Term Investors

Breaking news makes markets jittery--but the dust always settles

People pointing at sack of money on top of bar graph
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A note from Lou Carlozo: I couldn't have become an expert without learning from other experts: true leaders in the investment field. Robert R. Johnson, the President and CEO of The American College of Financial Services in the Greater Philadelphia area, is just such a leader. Time and again, his investor advice, observations, and command of the facts have made me look smart. Now he's done it again, delivering a wonderful guest column about today's state of market volatility, and how you as an investor can deal with it. Read on: This is actionable advice at its finest.

The watchword in the market today is volatility. With the recent Brexit vote, market commentators are focusing on the great uncertainty this development brings to global economies and what that means for the future of the world's financial markets.  It seems that everyone is predicting much greater market volatility in the wake of this economic/political disruption. 

Let's pause, take a breath, and put this into perspective. 

While this is the first time in memory a first-world country has seemingly voted in favor of a referendum to voluntarily enter a recession, the term "unprecedented" is frequently bandied about with respect to the uncertainty in the world's economies. The Lehman failure in 2008 was unprecedented, as were the bursting of the Internet bubble, negative interest rates, and the stock market crash of 1987.

It seems that we consistently experience unprecedented global economic events and somehow not only survive, but advance and thrive.

 

The popular narrative in the markets is that volatility is rising.  But, the simple fact is that volatility in prices -- that is, the observation that market values rise and fall -- is nothing new and is nothing to get worked up over. And, the evidence actually shows that a common measure of volatility has remained essentially unchanged over a 90-year period.

 

Most financial professionals measure volatility via the calculation of the standard deviation of returns. This is a quantitative measure that essentially indicates how widely returns deviate from an overall average return. For instance: If annual returns over a three year time period were 8 percent, 10 percent, and 12 percent, the average return was 10 percent and the returns did not deviate much from that average.  

On the other hand, say the returns over a three-year period were minus 10 percent, 10 percent, and 30 percent. As in the previous case, the average annual return was 10 percent, but the standard deviation from that average was substantially higher.  

Now, of course, most investors dislike risk and prefer less volatility.  That is, they prefer a lower standard deviation to a higher standard deviation. It is much easier to sleep at night when volatility is low. The common narrative is that high-frequency trading, falling commission rates, do-it-yourself trading, and a 24/7 financial news cycle have led to much greater volatility.

But simply the perception of increased volatility has unfortunately led many investors to make emotional and irrational decisions that have cost them in the long run.

 

In an article forthcoming in the Journal of Wealth Management, Professors Ken Washer and Randy Jorgensen from Creighton University, and I, found that when measured on a monthly basis, volatility In the S&P 500 has not discernibly changed over a very long period of time. Monthly volatility as measured by standard deviation was slightly less than 4 percent in 1940 and was slightly more than 4 percent in 2014. 

The problem is that investors frequently focus on periods much shorter than a month and here the evidence is a substantially different. When measured on a daily basis, volatility has more than doubled since 1940. Daily standard deviation was less than 0.50 percent in 1940 and has risen to over 1.00 percent in 2014. 

But, why do people focus on daily fluctuations, instead of taking a longer time horizon?

 

The answer is, because they can.

One of the biggest assets held by Americans is equity in their homes. Yet, people don't worry about daily fluctuations in home equity values.  Why?  Because they aren't provided that opportunity. The difference with your home and your retirement account is that you don't have someone quoting you a price at which they will buy your house every minute -- make that every second -- of the day. If you aren't planning on selling your house, why should you care what your house is worth from minute to minute, day to day or even monthly?  Likewise, if you aren't planning on retiring in the near future, why should you care what your retirement account is worth?

Recently comedian John Oliver did a segment on his popular show Last Week Tonight on retirement planning. The piece emphasized that investors should take a long-term view and check the value of their retirement accounts as often as they Google "Is Gene Hackman still alive?"  That is, about once a year. 

Retirement investors with a long time horizon should simply adopt a strategy of dollar cost averaging into a low-fee equity index fund. That is, they should consistently invest every month into a broadly diversified portfolio of common stocks such as the S&P 500 -- and, make those disciplined investments whether the market is trending upward, downward or sideways. 

The irony in the aftermath of the recent Brexit vote was the narrative about how volatile recent returns have been. Even though markets fell dramatically on Friday, the 3.6 percent drop in the S&P 500 was only the 180th worst day in history. To put this further into perspective, the S&P 500 opened 2016 at a value of 2038.20 and ended trading Friday at a value of 2037.41 -- virtually unchanged. If you had fallen asleep at the start of the year and awoken on Saturday morning to check your portfolio value you likely would have gone right back to sleep. 

As the Brits would have said prior to the Brexit vote, and have said for the past several generations, "Keep calm and carry on."  

And, by the way, Gene Hackman is still alive. 

Robert R. Johnson is president and CEO of The American College of Financial Services, an accredited, degree-granting academic institution founded in Bryn Mawr, Penna. in 1927. Dr. Johnson has authored more than 80 scholarly journal articles and is co-author of Investment Banking for Dummies, Invest With The Fed, Strategic Value Investing and The Tools and Techniques of Investment Planning.  

Lou Carlozo is an investment reporter for U.S. News & World Report.