Market volatility poses one of the greatest tests of investors' will. In the face of volatility—whether a dramatic one-day drop such as the October 1987 "Black Monday" correction or longer periods of saw-toothed performance such as those that unfolded in mid-2005—investors may derail their long-term goals with risky short-sighted strategies. For example, they may flee to the sidelines until it's "safe" to return or engage in market timing.
Market Corrections—A Normal Part of the Market Cycle
Although market volatility can be unsettling, it is quite a normal occurrence. Since 1900, the stock market has corrected by at least 10% more than 50 times. While these temporary deviations can be uncomfortable, the greater danger may be a short-term perspective. Conversely, a long-term outlook may improve an investor's prospects for success.
Market Timing: The Whipsaw Effect
We understand that investors want to be out of the market during volatile periods and in the market when times get better. However, those who try to predict market changes often end up "whipsawed," exiting the market as prices fall and getting back in only after they have risen again. The whipsaw syndrome is costly because it deprives investors of the potential for steady long-term growth. Just as it is impossible to predict precisely when a market correction will occur, it's equally implausible to anticipate the turnaround.
For example, consider a classic market study by the University of Michigan that demonstrated the futility of timing the market. The study showed that being out of the market even for short periods of time can have a significant, and negative, impact on portfolio performance—even during a bull market.
The Effects on Annual Return of Being Out of the Market
| 1982 - 1987 Bull Market |
| Full 1,276 trading days |
26.3% |
| Less the 10 best-performing days |
18.3% |
| Less the 20 best-performing days |
13.1% |
| Less the 30 best-performing days |
8.5% |
| Less the 40 best-performing days |
4.3% |
Source: University of Michigan
* The S&P 500 Index is generally considered representative of the U.S. stock market. Please remember that one cannot invest directly in any index. |
Furthermore, the best-performing days in this study were scattered over a number of months, with several of those months containing three or four of the biggest days.
The merits of a long-term approach are evident, not just in isolated bull markets, but also over longer time periods marked by ups and downs. For example, we see a similar trend if we consider the period from 1990 through 1999. The economy cycled through expansions and contractions, while stocks saw bull and bear markets of varying intensity. It's important to remember that volatility, negative news events and fluctuating sentiment remained ever-present—even during the upswings. But, investors who tried to avoid the short-term downs could have paid a steep price, as the table below shows.
Through Ups and Downs, A Fully Invested Approach Fared Best
| (1/1/90 - 12/31/99) |
| Fully invested |
18.2% |
| Less the 5 best-performing days |
15.7% |
| Less the 10 best-performing days |
13.8% |
| Less the 20 best-performing days |
10.8% |
| Less the 30 best-performing days |
8.3% |
| Source: Bloomberg |
Simply put, because the timing of the best days in the market is impossible to predict, the anxious investor who jumps out at the first sign of turbulence may lose much more than he or she hoped to save by getting out early.
Chasing the Latest Investment Trends
During times when a specific investment style goes out of favor or another style seems to be outperforming, some investors, rather than getting out of the market entirely, choose to shift investment strategies or investment managers. Just as trying to time your entry and exits from the markets can impair long-term returns, switching styles or managers because of temporary performance patterns can also severely handicap an investment plan.
While placing money in an investment program for one year or less is risky, changing managers or asset classes on a short-term basis is even more of a gamble. The range of expected returns is extremely wide for short periods because investment styles come in and out of favor; growth opportunities present themselves in different areas all the time; and both the markets and managers are subject to short-term shocks.
The Importance of a Strategic Long-Term Asset Allocation Plan
Although we believe that a key to successful investing is keeping the occasional market correction in its proper perspective and staying fully invested through the market cycle, we caution against a simple "buy and hold" strategy. Rather, today's volatile market requires a strategic asset allocation plan that involves continually monitoring an investment portfolio and making tactical changes as necessary to help meet long-term investment goals.
As you assess your portfolio with your investment advisor, we recommend the following approach:
- Start by reviewing and focusing on your long-term investment plan.
- Review your current level of risk tolerance. Determine whether your risk tolerance has changed since you formulated the plan and if the current balance between risk and reward will help you to reach your long-term goals.
- Evaluate your portfolio's long-term performance to determine whether it is meeting your investment objectives: keep in mind, one quarter's performance will not give you sufficient perspective. We recommend that investment plans be gauged by their success over the full course of a market cycle, which is generally three to five years.
Also, consider major trends and factors influencing the financial markets, rather than the short-term views disseminated by the financial press. Day-to-day news can distract from major secular trends and economic factors that are truly shaping the markets' long-term direction.