Market volatility shot up in early August, and the turbulence could be here to stay for a while. Analysts cite various reasons.
Investors remain jittery about the U.S. election campaign, high stock market valuations, and uncertainty about the economy and pace of central bank easing.
In addition, Canada, the U.S. and many European countries have had inverted yield curves for some time. This means short-term interest rates are higher than long-term ones—often a sign of economic weakness to come, though hardly an infallible one.
The result is markets could see more ups and downs before the turmoil runs its course. This may sound worrisome, but in fact, it’s quite normal.
Market selloffs can happen several times a year, and investors should be prepared to ride them out.
As U.S. investment fund manager Christopher Davis, a Berkshire Hathaway board member, put it, “A 10% decline in the market is fairly common—it happens about once a year. Investors who realize this are less likely to sell in a panic, and more likely to remain invested, benefitting from the wealthbuilding power of stocks.”
In fact, the selloff we saw in August—a 9.7% decline for the S&P 500 Index from the high point on July 16 to the low point on August 5—was nothing out of the ordinary by past standards. Since 2004, the Russell 3000 Index has seen declines of 3% to 49% within each year. The average intrayear decline was 14.9%.1
In other words, an investor owning the U.S. market should be prepared for a 14.9% decline in any given year, with many years seeing far worse. In one especially harrowing year—2008—the index fell a whopping 49%.
How can an investor steel themselves for such losses? It can help to know that even years with steep corrections often end the year in positive territory.
In 17 of the last 20 years, the Russell 3000 ended the year with a positive return. The average annual gain over the entire 20 years was 11.3%.
Indeed, this year, even if we include the summer’s selloff, stock markets have seen powerful gains since the start of the year. The Russell 3000 has returned 20.2% year-to-date as of August 31, while the S&P/TSX Composite Index was up 13.7%.
What kind of decline will we see during the rest of the year? We can’t predict the future, but we can plan for it. At PWL, our tilt to value and small-cap stocks means we hold less of the speculative AI and other tech stocks that have seen big losses in the past few weeks, as I noted in my blog in August.
As well, all our clients have portfolios with enough bonds to cover their needs for several years, far longer than the average bear market. This is to ensure we don’t have to sell stocks when they’re down.
In addition, bonds usually tend to act as a hedge against potential stock market declines. Bonds typically go up in price when stocks go down. That’s been the case in the recent selloff. Bonds rose, offsetting some of the fall in equities.
Bonds aren’t a perfect hedge, but they’re pretty good. Since 1928, the S&P 500 declined in value in 26 different years, and the average decline was 13.5%, investment manager Ben Carlson wrote in a recent blog. In 22 of those 26 years, 10-year Treasury bonds had a gain, averaging 4.3%.
“Most of the time bonds act as a good hedge against bad years in the stock market,” Carlson said. “There are no guarantees. Rising rates and inflation are not a great combination for bonds. But high-quality fixed income can help protect your portfolio from stock market volatility and recessions if and when they strike again.”
At PWL, we agree with this assessment. For this reason, we include a bond allocation in clients’ portfolios that matches their risk tolerance and needs for funds. It’s a good idea to periodically review your allocation targets and risk tolerance to make sure they still align with your expectations. This is especially true after a bout of turbulence.
What’s key is having confidence in your investment plan and sticking to it with discipline. A few normal market hiccups aren’t a reason to toss the plan out the window. Market rises and falls are an expected part of the journey. We assume these kinds of swings when we create financial projections and stress test those projections.
After a long period of growth, a dip is to be expected. With a solid plan in place, we can weather the storm and look forward to the next rise.
