How to Handle Volatility

For investors who only recently started participating in the stock market, 2019 has had its share of challenges. While returns on U.S. stocks are positive year to date, both May and August saw some dramatic selloffs. Indeed, part of the reason why the headline returns have been so strong this year is that returns in the fourth quarter of 2018 were extremely weak, and that set the stage for a strong rebound in the first quarter.

Is this volatility a problem? In short, no.

Volatility fluctuates based on where we are in the business cycle, but it is a normal feature of markets that investors should expect.

Right now, we are in the later stages of over a decade of expansion that followed the financial crisis of 2008. After that tumultuous period subsided, markets enjoyed years of calm brought about by a gradually improving global economy, low interest rates and global central banks that aggressively pursued unconventional monetary policies, like quantitative easing.

That started to change in the past year and a half as global economic growth picked up speed, raising concerns about inflation and what that could mean for the future path of monetary policy. As central banks withdrew some economic stimulus, financial conditions tightened and global growth started to slow. It hasn’t helped that trade tensions, particularly with China, have been worsening throughout the year. The latest uptick in volatility seems attributable to fears of a more pronounced global economic slowdown, as well as an increase in uncertainty.

As is common in markets, downdrafts caused by these concerns and data points have been shortly followed by rallies that take the market to new highs. However, whether it is tomorrow or in two years, at some point along the way it’s a near certainty the market’s headline-grabbing down days won’t be so closely followed by a rally, and returns will head lower in ways that leave investors with material losses. That is the typical way the market responds to economic recessions, events that are a feature of market economies as inevitable as the turning of the seasons. 

Does that mean you should sell now?  Not necessarily. The next recession could be months or even years away. It’s extremely difficult to predict the timing with the accuracy needed to profit from such a prediction.

More to the point, it is easy to get such a prediction wrong, which can be costly. While we do tilt our portfolios more aggressively or more conservatively based on our market outlook, the data shows that individual investors who radically reposition out of stocks in an attempt to catch the tip of a market top reliably miss out on gains more than they prevent losses, and generate excessive transaction and tax costs along the way.

While “buy low, sell high” may sound like time-honoured advice, the challenge of getting it right means it rarely is a good way to make decisions in practice. Indeed, individual investors who stay in cash waiting for a bear market to come and go, often lose patience as stocks continue to go up. This results in their missing out on gains rather than preventing losses. That costly mistake is the reciprocal of another, wherein panicking investors sell during a major market selloff, and remain on the sidelines too long as stocks rebound, effectively locking in their losses. The prevalence of these value destroying behaviours helps to explain why individual investors as a group tend to dramatically underperform market benchmarks.

There is a caveat to the generally superior buy-and-hold approach, which is that seeing a paper loss in your portfolio doesn’t feel good. Some investors would rather take less risk, which may mean giving up some long-term returns, in order to reduce the period of time they may need to wait out losses, making for smoother sailing. 

Another caveat to the buy-and-hold idea comes when investors take a goals-oriented approach. That’s where a financial adviser can help by talking through goals and priorities and reassessing your portfolio based on where you stand. For instance, if you are saving towards a goal and have made good progress, it may make sense to take on less risk, regardless of the market outlook. This is for two reasons. First, it intuitively makes sense to take less risk when you have more to lose than to gain regarding the goals you care about. Second, for additional peace of mind that your progress won’t be jeopardised, you may desire the lesser uncertainty that can come from a more conservative blend of stocks, bonds and cash.

If, like many of us, you have more progress to make and more road to travel towards achieving your goals, riding out the market’s jitters can be the best advice. Our research shows that markets are most predictable when you have a seven- to 10-year time horizon (due to how well current yields and valuations predict returns over those horizons). Our forecasts continue to suggest that stocks will outperform bonds and cash over that time horizon.

Bottom line: Working with your financial adviser can help you keep a steady head and remember that investing is a long-term proposition. Maintaining your eye on the horizon is your best strategy as an investor.    

 

For more on how to handle volatility, or a copy of our full report, speak to your Morgan Stanley financial adviser or representative. Plus, more Ideas from Morgan Stanley's thought leaders.