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Stocks Are More Volatile Than You Think

August 20, 2019
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We always seem to forget how volatile stocks are.  The graph above covers the 40-year period from 1979-2018, a stretch where the S&P 500 returned +11.5% annually.  This return didn't come from earning +11.5% every year however, let alone 1% every month.  The blue bars illustrate the wide range of annual returns--from +37.6% to -37.0%.  

If you look closely, you'll also see how extreme the intra-year returns are.  Almost every year sees a temporary loss of at least -10%, and many positive years see -20% or more temporary declines.  The average of all intra-year losses is almost -15% per year.  1987 witnessed a loss of over -30% but the year still ended with a gain!

The graph clearly shows that you don't have to avoid stock market losses to have a positive investment experience.  On the contrary, it appears the significant short-term volatility of stocks is a reason why they have historically delivered a premium return.  The Bloomberg Intermediate Bond Index had less volatility during this period but the cost was almost 5% per year lower returns.  In investing, as the saying goes, no pain, no gain.

Despite how common stock market volatility might be, some investors still consider trying to time the market by selling stocks before they drop, and buying them back before they recover.  But that's a risky proposition, much of the stock market's biggest gains have come from just a small number of really good days.  The chart below shows that missing just a few of these days--which often come right after really big losses--can cost you much of the long-term return of stocks.

So far we've seen that stocks are volatile and trying to avoid that volatility from market timing can make a bad situation worse.  Asset allocation, however, offers us a potential answer, whether our goal is higher returns for a given amount of risk, or less risk for a given return.  

The chart below shows the long-term growth of the S&P 500 contrasted with two globally diversified index allocations.  The Dimensional Equity Balanced Strategy Index is an all-stock allocation, spread across US and non-US markets, tilted to higher expected returning small cap and value stocks.  Due to the diversification benefit of combining separate asset classes, the Dimensional Equity Balanced Strategy Index doesn't have greater volatility than the S&P 500, the former had a monthly standard deviation of 14.86, the S&P 500 14.80. The Dimensional Equity Balanced Strategy Index did, however, have higher returns: +13.3% per year compared to +11.5% for the S&P 500.  1.8% higher annual returns had a big difference on long-term wealth accumulation, $1 grew to $147 in the Dimensional Equity Balanced Strategy Index versus just $78 in the S&P 500--almost double the growth.

The Dimensional 70/30 Balanced Strategy Index is weighted 70% to the Equity Index, but dilutes the stock exposure with 30% in short-term, high quality bond indexes.  The result is S&P 500-like returns, +11.3% per year (vs. +11.5% for the S&P 500), but with 30% less monthly volatility.  This reduction in risk shows up most during bad markets; the worst three years since 1979 for the S&P 500 saw losses of -23.7% on average, the 70/30 Index had an average loss of only -10.2% in these three years.  That's a dramatic difference in short-term declines without sacrificing long-term returns.

Stock market volatility is a fact of life, but not something you should try to avoid through market timing.  Getting in and out of the market could result in stock market risk without earning the full stock market return.  The good news, though, is through intelligent portfolio construction you can design an asset allocation that squeezes more expected return out of stocks through global diversification and small cap/value asset class exposure or market-like returns with less volatility by also adding an allocation to short-term bonds.

Stocks are more volatile than you think, but there are smart decisions you can take to improve your overall investment experience.  

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Source of data: DFA Returns Web

Dimensional 70/30 Balanced Strategy Index = 70% Dimensional Equity Balanced Strategy Index, 30% Dimensional Fixed Balanced Strategy Index, rebalanced monthly.

Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.