It sure has been a bit bumpy in the markets over the last month or two. Volatility is nothing new, but it does have a way of dampening the holiday spirit! While we all know that volatility exists, it doesn’t mean we like it, or know what to do (or not to do) when it strikes.
Why is the market volatility happening? As always, there are many possible causes and influences. Recent high-profile political news, such as the trade battles with China, affect the markets. Something a little more esoteric is watching a common yield comparison: the difference between a 2-year U.S. Treasury Bond and a 10-year U.S. Treasury Bond. In typical market conditions, 2-year interest rates are usually lower than 10-year rates, because two years from now is generally deemed to have more certainty than ten years from now, and therefore investors are taking on less risk and getting lower returns for that increased certainty. What gets interesting, then, is when the yield curve “inverts” and the 10-year rates become lower than the 2-year rates. A yield curve inversion has a fairly reliable history of foretelling recessions, which usually follow rate inversion by 18-24 months. An inversion hasn’t happened with the 2-year and 10-year Treasuries, but the spread, or difference between these rates, is only about 0.14%. To put that in perspective, the difference in rates on 12/31/2013 was much larger, at 2.66%. Rest assured that we are always watching the spreads, and numerous other indicators, with portfolio construction and you, our clients, top of mind.
At Taurus Capital, our investment approach is based on the knowledge that markets can and will fluctuate. We can’t control volatility, but we can expect it. Our portfolio construction and diversification methodology focuses on what we can control, letting the markets work to our advantage and increasing the odds of success. When the market is bouncing around as it has been, it can be difficult, and may even seem counterintuitive, to stay the course, but that's often exactly the best decision.
To get our heads out of finance for a moment, think about a soccer goalie defending against a penalty kick. The goalie doesn’t know what the kicker plans to do or where the ball is going to go, but he/she has to make a split decision on how to play the ball – dive left, dive right, or stay at the center of the net.
Behavioral economist Ofer Azar collected data on more than 300 goalies and discovered that 94% of the time, goalies chose to dive left or right. Those who dove left stopped 14.2% of the shots, and those who dove right stopped a mere 12.6%. Goalies who didn’t try to predict which way the ball was going and stayed in the middle of the goal stopped the ball 33.3% of the time. Despite those statistics, amazingly, only 6% of the goalies chose to play the center of the net.*
Azar interviewed the goalies about their penalty kick decisions – why did so few play the odds and stay in the center? The goalies revealed that they would rather be scored on diving the wrong direction than they would standing in the center of the net. It wasn’t logical, it was emotional. Taking action and picking a direction – even if it decreased their odds of making a save – felt better than taking no action at all.
Azar applied his soccer research to the behavior of investors. Similar to the goalies he studied, uncertainty and fear can cause investors to feel a powerful urge to ‘”do something’” even when that "something" has been proven to not be the most effective. (And that’s putting it kindly for investors. It can actually be detrimental!)
Why is timing the market (“doing something”) so challenging? One of many reasons is that the best and worst trading days tend to occur very close together. If you follow these moves, you might notice that a down 500-point day might be followed by an up 500-point day. Missing timing buys and sells during these random, highly volatile trading days can significantly and negatively impact your portfolio. As shown below, these swings often happen within days of each other:
S&P 500 Index daily returns, Dec. 31, 1979 through Dec. 31, 2017
Time helps reduce volatility. On a day-to-day basis, stock market returns are only a little better than a coin toss (54%), but over time, your odds of positive returns improves dramatically.
Investment returns increase in proportion to time. Volatility increases more slowly.
During times of market stress, it’s helpful to keep in mind that historically, the stock market delivers far more often than not, especially in the long run. In 2008, many investors gave in to the feeling of needing to “do something” even though the research clearly shows that sticking with an appropriately diversified portfolio yields the greatest odds of success (by far). But, for many, it was an emotional decision, fueled by the fear of doing nothing. Those who stayed put have benefited from the market recovery since then, but it has been quite damaging for many of those who tried to minimize their losses.
The bottom line: Your portfolios are constructed in a way that balances the mutual objectives of diversification, risk tolerance, cost reduction and tax efficiency. These are the items we can control on your behalf. Working together, we can increase the chances for your investment success by resisting the temptation to take action for the sake of action and letting the markets work in your favor over time. Think of the soccer goalies. You are better off staying the course of your investment approach even if it feels uncomfortable, knowing it gives you the greatest odds for longer-term success!
*Source: Wray Herbert, 2010. "On Second Thought: Outsmarting Your Mind's Hard-Wired Habits." New York: Broadway Paperbacks.