How Investors Should Navigate The Recent Volatility

After the stock market (as measured by the S&P 500) dropped by 3.55% yesterday, bringing the decline to nearly 13% in 2022 (and almost 17% for small-capitalization stocks), many investors are panicking.

Losing money is an awful experience and losing money for clients who have entrusted you with their hard-earned savings is even worse. However, there is a significant difference between a temporary loss on paper and a permanent loss of capital.

The past few years have had very little volatility (with the notable exception of March 2020), so this sharp reversal is especially difficult. However, in a typical year since 1980, the stock market has declined by an average of 14% from peak to trough, with midterm election years having historically produced large intrayear pullbacks (17% on average, according to LPL Financial). Midterm election years also tend to produce strong year-end rallies, although admittedly this year has been anything but typical.

Investor Worries

Today’s investors are worried about a host of things, from inflation and interest rates to COVID-19, lockdowns and an economic slowdown in China, and the war in Ukraine. Though I am not downplaying the seriousness of these issues, investors can always find reasons to sell equities. Since 1940 market participants have endured multiple wars, the assassination of a sitting U.S. president, the economic malaise of the 1970s, the September 11 attacks, the financial crisis and the Great Recession, and more recently the COVID-19 outbreak—but investors who have stayed the course and held on have been richly rewarded.

As mentioned above, one of investors’ biggest worries today is inflation. Inflation has been reasonably tame for the past 25 years or so but has recently soared to a 40-year high. Although historically stocks do poorly when inflation rises, they do quite well after it peaks. According to data from Bloomberg and Leuthold, since 1950 the S&P 500 index has increased an average of 13% over the 12-month period following each of the past 13 major inflation peaks. The question, then, is whether inflation has peaked. Of course, no one can know for certain, but signs do seem to indicate that runaway inflation may be ending relatively soon.

Staying the Course

In my opinion, the worst thing investors can do is sell during a panic. Since 2001 the S&P 500 has increased by ~7.5% per year, yet the average investor has received a return of only 2.9% per annum. Why? Because people buy and sell stocks based on emotional reasons and not fundamental ones, buying in when the outlook is rosy (and valuations are highest) and selling out when times are tough (and valuations are lowest).

I have no idea how much longer this relentless selling will continue, but I do believe there are a whole host of high quality businesses that are positioned to do well over the medium to long term that are selling at significant discounts to what they are truly worth. The near term will likely be bumpy, but I’m optimistic about the future. In fact, now is when investors should be thinking about increasing their equity exposure: historically, the best time to invest is when you feel the worst. Even highly experienced and successful investors find taking this plunge difficult, particularly when prices keep falling, but buying great businesses at marked-down prices and holding them for the long-term is historically how the best returns are made.

Why Don’t You Sell Now, Then Buy When the Situation Stabilizes?

Clients sometimes ask us why we don’t sell in a downturn and wait for the situation to “stabilize.” As simple as it might sound, such an idea is impossible to implement and poses a serious risk to investors’ financial well-being. As famed investor Howard Marks pointed out in his recent memo, missing just a few days could significantly eat into your long-term return. According to data from JP Morgan, during the 20-year period 1999-2018, the S&P 500’s annual return was 5.6%, a figure that dropped to only 2.0% for investors who missed the 10 best trading days (roughly 0.4% of the total trading days during the period). Investors who were unfortunate enough to miss the best 20 trading days made no money at all. The market’s best days tend to follow its worst days, and investors who sell out at these times of maximum pessimism are likely to miss the rebound.

Reasons for Optimism

Today’s headlines are certainly frightening, but not everything is doom and gloom. U.S. consumers are in reasonably good shape with unemployment levels and debt levels at historic lows, major U.S. banks are well capitalized, and the worst of COVID-19 appears to be behind us. In fact, one of the most bullish signs is how negative the current sentiment is, with a recent American Association of Individual Investors survey the most bearish since March 2009 (the month the market bottomed and advanced 23% for the year).

Like everyone else, I am concerned about the recent stock market volatility. How could anyone not be? There’s no sugar-coating it—volatility is awful to go through. But corrections are an integral part of the investment process: Without them, stock pickers like us would have no chance to purchase stocks at deeply discounted levels. It is this volatility that gives us the potential opportunity to generate superior long-term returns compared with other types of investments.

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Source: https://www.forbes.com/sites/jonathanboyar/2022/05/06/navigating-the-recent-volatility/