Note: To view recorded webinar where Zach discusses market volatility and reviews 2018 market activity, please visit: Understanding Market Volatility and 2018 Market Review. For a more in-depth look at 2018 Market Activity – read 2018: A Year of Volatility.
Football coaches are always preparing their players. The team may have had a tough season, but it’s the games ahead that matter most and there is always a desire to learn lessons from the past season and refocus to be prepared for what may come next. Towards the end of the 2018 “season” in the markets, we heard investors repeating many of the same questions, so we thought it would be good to respond. Here are a few lessons you can take to the playing field in 2019, hopefully, to help you better understand what you are seeing and what your advisor is recommending.
Why is the market so volatile?
The first question we heard a great deal was “Why is the market so volatile? How can it go up and down 500+ points in a single day?” This is a great question and highlights two important facts. The first is that, in general, markets are forward-looking; they aren’t as concerned with what is happening today, but what will happen going forward, or the follow-on impact of today’s news 6-12 months (or longer) down the road. Because the future is uncertain and unknowable, the opinions of investors may diverge considerably. Imagine that there are only two futures: one in which US/China relations get worse and we experience a global recession or one in which a trade deal gets made and global growth reignites. In those two scenarios, stocks would have a very different value in 12-24 months and beyond. Obviously, there are millions of other factors and possible “futures”, but just those two highlight why stocks can be volatile. The fewer variables and less divergent the “futures”, the more stable asset prices become. With more uncertainty, there is more volatility. This is not to mention the effect of both the news cycle and human emotions that fuel the opinions of investors.
Buyers and Sellers Transacting That Day
The second item to remember is that market prices each day are impacted by the buyers and sellers transacting that day. So, of the millions/billions of investors around the world, it is only the ones who come to the market that day to buy or sell that set the price of all assets. So, your “buy and hold” long-term investors may not show up at all (theoretically) one day and the only buyers/sellers in the market are short-term hedge funds or high-frequency traders. Is it any wonder that some days the market activity is really volatile? Which brings us to another critical point to remember …
Investors and Traders
We all know the market is made up of buyers and sellers, but did you know it is also made up of investors and traders. In the case of an investor, the selling or buying occurs due to a difference of opinion on the value of a company. Said another way, or the difference being highlighted is that of time horizon and/or objectives of investors. For example, a seller may no longer have the appetite to invest for a 3-5+ year period and thinks $100 is a good price to sell a stock, while at the same time the buyer does have a long time horizon and thinks $100 is a decent entry point. In this case, the difference in perceived value or time horizon, both buyer and seller are happy with the transaction as they have accomplished what they wanted. There is, however, another participant in the markets, the traders. A trader isn’t particularly concerned with the stock (company, product, management, etc.) or commodity being traded, he simply is buying and selling quickly to turn a profit. Today, high-frequency traders (HFTs: computer programs/algorithms) account for 2/3rds or more of the trading activity on any given day. These programs may trade multiple times, not just in a day, but in a second (they can trade within a micro-second). While the benefits and costs of HFT to the market are greatly debated, these programs are generally momentum driven and can exacerbate market moves in both directions (aka: the robotic herd). The HFT computer systems have complex formulas that tell it to buy or sell more. Oftentimes, the huge swings in prices in a given day are attributable to these programs. It’s not that the price movement in assets isn’t started by investors based on real news, but these HFT’s pile on and can exacerbate volatility.
To be clear, over time, we believe the collective wisdom of the markets, even with HFTs and traders being involved, arrives at the “right price”; that real and accurate information is embedded or “priced in” to stocks/bonds/etc. Warren Buffet used to explain that in the short-run the market was like a voting machine (popularity, etc), but in the long-run, it was more of a weighing machine (accurately weighing the value of a company). We still believe this to be the case, but hope this explanation helps you better understand the erratic daily moves you often witness.
One of the most challenging exercises in investing is understanding your actual time horizon for your investments and putting short-term performance in context. At Bridgeworth, part of the diversification process is not just dividing portfolios up in different assets just for “diversification” sake, but to diversify portfolios in relation to time horizon. Our cash and bonds are less volatile and able to have a shorter time horizon to address more immediate needs. Our equity exposure, on the other hand, is not intended for those purposes, but rather is used for growth potential over the coming 5+ years. For clients with income or cash needs, this is one of the main reasons why you have bonds and other less-volatile assets in your portfolio.
Research shows that, in any given day, there is only about a 50% chance of a positive return, but at one year, the probability goes over 70% and for 5-10 year time periods the probability is in the 90%+ range. So, when we say we don’t think day trading is advantageous and instead prefer to be long-term investors, it’s not because we can’t daytrade, but rather we prefer a strategy that has a higher probability than flipping a coin. With that being said, we recognize it is very hard not to look at the daily scoreboard of the market and be emotionally drawn into playing a shorter-term game. This behavioral discipline is one of the biggest values we can provide to investors; as a client, you have to be willing to follow our lead.
Risk of Missing Positive Trading Days
Lastly, and closely related to the previous point on short-term investing, is the risk of missing positive trading days. The reason that Bridgeworth advisors prefer to “stay invested” in an allocation is highlighted by the last several months of 2018 where you could see 5% swings in stock values in a single day (either up or down, sometimes both). Volatility in the market causes more volatility (because of HFT), sort of like aftershocks following an earthquake, and often the biggest “up” days in the market follow the biggest “down” days. It is true that momentum in one direction can build, but there isn’t any sort of guarantee that reversals won’t happen. Missing just a few of the best trading days (which again, are often after the worst), will significantly lower long-term returns. As JP Morgan’s David Kelly says, “markets don’t settle down, they settle up”; meaning if you wait until they “settle down”, then the recovery could have already happened. We prefer to build portfolios in advance of volatility, make changes when fundamentals change and stay emotionally disciplined when others lose their cool.
Some will say that following an investment strategy like ours is “easy”, but that doesn’t mean it isn’t hard to do. If knowledge was all that was required, we would all have six-pack abs, but the truth is that emotional discipline is hard. Research shows that the pain of losses is twice as great as the joy from gains. Based on my experience, I think that the pain felt is much greater than that. Even though most investors experienced great gains in 2017 and previous years, losses in 2018 are what you remember and really feel. Knowing this, we must do what we can to stay disciplined in order to help you reach your long-term goals. We thank you for your trust and always welcome questions and discussions about these and other topics.
The opinions and information contained herein have been obtained or derived from sources believed to be reliable, but Bridgeworth makes no representation or guarantee as to their timeliness, accuracy or completeness or for their fitness for any particular purpose. The information contained herein does not purport to be a complete analysis of any security, company, or industry involved.
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Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.
Past performance should not be taken as an indication or guarantee of future performance. There is no guarantee that any forecasts made will come to pass.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.