It has been said that golf is an easy game, it’s just hard to play. Much the same could be said of investing.
The principles of long-term investment success aren’t particularly complicated. Construct a well-diversified portfolio appropriate for your risk and return needs. Stay the course and let compounding work its magic over time. Easy, right?
And yet…it isn’t. Emotions get the better of investors. Fear and greed are constantly whispering in their ear. They worry about the downturns and second-guess themselves in the upturns, wondering if they are doing the right thing. They can’t avoid the temptation to make “adjustments” and “tweaks” to their portfolio based on short-term market trends. They sit on cash that should be invested, worrying that the market is too high or too low.
Avoiding these temptations is made infinitely more difficult in our modern world. Every time investors pick up their phone or turn on the TV, they are bombarded with a fire hose of information, much of it worrisome. The spin may change depending on the day, but the underlying message from the “experts” is always the same: Don’t just sit there – do something!
This message seems to peak whenever October rolls around, and we are seeing it again this year. Stories abound about the so-called “October Effect” – the (supposed) tendency for stocks to experience declines more frequently and more severely in October than the other months of the year. The pundits make competing predictions about which sectors investors should overweight or underweight and how much cash to raise to protect against a downturn.
These pundits might find it an inconvenient truth that October isn’t the worst month historically for frequency of stock declines; that distinction actually belongs to September. What is true about October is that it is historically the most volatile month of the year and has a higher standard deviation than any other month on the calendar. Given that three of the biggest stock-market percentage declines of all time have occurred in October (1929, 1987 and 2008), it isn’t a big surprise that investor anxiety rises when the pumpkins hit the stores. The historical spike in volatility in October is a reflection of that anxiety.
But even accepting that October is historically the most volatile month of the year for stocks, the question remains: What should long-term investors do with that information?
There are two important things to keep in mind about volatility, regardless of how October 2019 – or any other month – plays out for stocks:
- Volatility is a necessary component of stock investing: Investors demand more upside when they take on more risk. Cash has lower volatility and therefore lower expected returns than bonds. Bonds have lower volatility and lower expected returns than stocks. Large stocks have lower volatility and lower expected returns than small stocks. And on and on. There is simply no way around the risk/reward equilibrium. If volatility wasn’t an inherent part of stock investing, investors wouldn’t reap the higher expected returns that stocks generate over bonds and cash. While living with the short-term ups-and-downs that are a part of stock investing isn’t fun, it is the medicine we must take to obtain the higher long-term returns we will need to protect our purchasing power against inflation.
- Volatility becomes much less of a factor over time: If the price of your house declines by 20%, do you rush to sell it before the value drops even more? Most homeowners would never take such rash action, and yet every time the stock market goes into a steep decline we see large numbers of equity investors run for the exits. Some of this is attributable to the liquidity of stocks compared to real estate; it isn’t possible to bail out of your house at the push of a button, but it is possible to do that with your stock portfolio. But it also speaks to the lack of a long-term view many investors have about stocks. Homeowners expect to be in their houses for the long term and don’t worry about the short-term fluctuations, but they don’t take a similarly sanguine view with their stock portfolio.
After the market crash of October 1929, the Dow Jones Industrial Average stood at 230. The Dow fell to a level of 1,738 after the October 1987 plunge, and it fell to 8,451 on October 10, 2008 after the initial selloff during the Financial Crisis bottomed out. And yet here we are today, with the Dow (at present) hovering around the 26,000 level. The undeniable reality is that stocks have overcome every downturn they have ever experienced – given enough time.
Alas, while stock volatility isn’t an issue over the long run, most stock investors don’t stay invested long enough to let it runs its course. The 2018 Quantitative Study of Investor Behavior by Dalbar & Associates found that the average holding period for an equity mutual fund from 1998-2017 was just 3.55 years! There is a significant opportunity cost that investors – especially taxable investors – incur when they constantly move their money from fund to fund, or in and out of the market. Transaction costs, taxes and just plain bad guessing all add up to deny investors the returns that were there for the taking if they had just stayed put. We can see the cost of this behavior in the following chart comparing the average annual returns of equity-fund investors to the S&P 500 over the past decade (source: Dalbar & Associates QAIB Study 2018):
It is a sad reality that the average equity-fund investor attained the equivalent of bond-fund returns over the past decade. Clearly, behavior is a major component of investment success and is the one factor that gets the least amount of attention. This is why having a disciplined investment management plan and sticking to that plan regardless of short-term market conditions will have the biggest impact on your long-term wealth.