How to “Stomach” Market Volatility

Wednesday, April 4th, 2018

Good Morning Relaxing Retirement Subscriber,

During one of those days in February when market prices fell 3 to 4%, or over “1,000 points” as our friends in the financial media choose to refer to in order to embellish the story and capture your attention, one of our Relaxing Retirement members asked me a great question, “how can you be so confident even when markets are crashing?”  (those were her exact words)

Even though they have been members since well before the 2008-2009 crash, she admitted that the emotional reactions of her friends to the 24/7 news coverage every time market prices fall was getting to her.

I actually don’t blame her.  Unless you hide out in a closet, you can’t escape hearing about it these days with television, radio, and internet news in front of your eyes at all times, especially if you have an iPhone and/or an iPad!

Contrast that with October 19, 1987 when prices fell over 22% in one day!  Now that’s a crash!

On that day, the chairman of the Federal Reserve, Alan Greenspan, whom you would think would be completely aware of significant market movements moment by moment, was completely unaware of the crash for over four of the six and a half hours the market was open because he was on an airplane and there was no coverage in airplanes at that time.

Imagine that!  How times have changed.  Today, any kid with an iPhone can instantly discover the trading price of any stock in the world.

System vs. Whim

The short answer I provided our members got a good laugh out of them: Vanguard founder John Bogle had a great response when asked how he handles market crashes, “I get scared just like everybody else when market prices fall quickly.  But, then I go and read everything I’ve written over the years to set myself straight!”

That’s actually not too far off!

The longer and more detailed answer I provided our members took a little bit, but they recommended that I share it with all of you.

The most important part is that we rely on a process and a system.  We don’t rely on a whim, or a hunch, or by deluding ourselves into thinking that we or anyone else can consistently predict short term movements in market prices.  I fully embrace the fact that I can’t and nobody else can either.

My answer also had nothing to do with making any short-term market predictions.  Not only is this an impossible task, but as I’ve discovered over the years, and will soon share with you, it’s completely unnecessary for the rational long-term investor with a plan.

Put bluntly, any time spent attempting to determine what markets will do in reaction to some stimulus/news story is a complete waste of your energy.

The Progression

Here is my recommendation for dealing with heavy doses of market volatility.  It begins with completely de-emotionalizing yourself, so let’s begin with some facts we’ve discussed over the last few months which I recommend keeping at the forefront of your mind at all times:

  • We are all trying to solve a long-term problem, not short-term, i.e. to have our Retirement Bucket™ support our desired lifestyle and remain intact for the remainder of our lives. How long will that be?  Well, the average joint life expectancy of a 65-year old couple is 27.1 years, to age 92.  For a 75 year-old couple, it’s 18.4 years and age 93.4.  Given this, despite what the financial news media wants you to buy into for their purposes, we’re all long-term investors with the overwhelming majority of our Retirement Bucket!
  • We live in a rising cost world. In order for us to sustain our desired standard of living, our incomes must  And, in order for our incomes to rise to battle inflation and maintain our purchasing power, the value of our Retirement Bucket™ holdings must also rise.
  • Over the last 72 years since World War II, the value of the S&P 500 Index, our proxy for “the market”, has grown in price from 13.49 to 2,683.73 or just shy of 199 times in value! (You may want to take a moment to read that again) Markets have done a wonderful job of preserving our purchasing power throughout history.
  • This increase in value does not include dividends which we will get to in a moment.
  • Along the way, there have been 56 market pullbacks of at least 5%, with 9 bear market corrections between 20% and 40%, and 3 mega-bears over 40%, two of which were in the last 20 years.
  • The average length of time for the 9 bear market corrections to revert back to pre-bear prices was only 14 months. Bottom line: market volatility, corrections, and crashes are a given and a part of the long term investing experience.  They are not fun, but until we discover a way to rationally deal with them, we will never capture the wonderful returns markets have provided for us.

Reversion to the Mean

At the risk of getting over technical, there is a concept known as reversion to the mean which is very important for you to understand.  Vanguard’s John Bogle once said, “reversion to the mean is the iron rule of financial markets.”

Essentially, if you plotted the various short-term returns of a globally diversified equity portfolio, you would discover several things:

  1. Prices move wildly and randomly on a daily basis.
  2. There is a bell-shaped distribution of returns with a very large percentage of daily returns falling within a very small, concentrated range.
  3. And, a small percentage of returns falling outside of that heavy concentration of returns.

What this demonstrates is that, despite short-term movements outside of the “normal” distribution of returns, market prices eventually gravitate back toward the very long historical mean.

Time

What this means for you is investing is a long-term process and you must use time to your advantage.  In the short-term, prices move wildly and randomly and they don’t appear to make much sense.

In the long run, however, they make perfect sense and prices tend to revert to the mean.  We simply have to have a workable strategy in place to deal with short-term market volatility and hang in there long enough to capture rational long-term returns.

1. Global Diversification

Given all of this, the first tool in your Retirement Bucket Strategy™ toolbox to “stomach” market volatility and remain confident is to play the higher probability percentages of owning a strategically allocated, globally diversified portfolio using low cost index and asset class funds which are built to capture the returns of various asset classes is a cost-efficient manner.

As opposed to attempting to “beat the market” by relying on superior selection of individual stocks, or actively managed mutual funds which have a horrible long-term track record of outperforming their respective index, take advantage of the opportunity to cost-effectively own a piece of close to 10,000 businesses (stocks) throughout the world.

By strategically diversifying your holdings in this manner, you position yourself to not only capture the returns of global capital markets as a whole, but also the potential of even better returns by taking advantage of the long-term risk premiums which have been provided by certain asset classes throughout history.

2. Liquidity

Your second tool to “stomach” market volatility is sufficient liquidity.  As opposed to someone who is still supporting themselves with the income from work, you are withdrawing funds from your Retirement Bucket™ of investments each month to support your lifestyle.  Because of this, short-term stock market price volatility can have a downside impact on you if you are forced to sell in a down market to provide the cash you need.  However, the downside impact is only on a very small portion of your Retirement Bucket™.

The mistake most retired investors make is assuming that all of their investment holdings are impacted by short-term market volatility.  If you are like most, you withdraw less than 5% of your Retirement Bucket each year.  And, most withdraw on a monthly basis, so that’s less than 1/2 of 1% of the value of your Retirement Bucket each month.  Given this, there is no need to shield your entire Retirement Bucket from short-term market price volatility. (Very important!)

Assuming for a moment that you have done your homework and you are crystal clear on your level of Retirement Bucket Dependence™, and you withdraw 5% of your Bucket per year, if you have 25% of your holdings held in money markets and short-term bonds, you have five years of your anticipated withdrawals immune to the short-term price volatility of stocks.  5 years!  (see historical lengths of market corrections earlier)

By having a carefully targeted portion of your holdings outside of short-term price volatility we experience with equities, you buy yourself time….time to hang in there with your equity holdings long enough (without panic selling during temporary market corrections) to capture long-term returns!

3. Dividends

During the phase in your life when you are “living” on your Retirement Bucket™, the third tool to help you deal with temporary market corrections is understanding the role that dividends play for you.

First, a few facts to keep in mind at all times:

  • While everyone always focuses on the current “price”, from 1950-2017, 30.6% of the total return of the S&P 500 Index came from dividends. 69.4% came from price appreciation which is the only measurement typically reported.
  • In 1960. the dividend on the S&P 500 Index was $1.98 on a price of $58.03. In 2017, the dividend was $48.93 on a price of $2,684, i.e. income grew from $1.98 to $48.93 over those 58 years!
  • While CPI inflation has averaged around 3% per year during those 58 years, dividends grew by 5.76% per year, or almost twice the rate of inflation.
  • Dividends have rarely gone down throughout history, and those reductions have been minor especially when measured against market correction prices.

Think of the role dividends play at this stage in your life when you are withdrawing funds to support your lifestyle.  During severe, yet normal and temporary market corrections, dividends provide significant liquidity, thus even more time to hang in there with your equity holdings long enough to capture long-term returns!

Not all stocks provide the same level of dividends, but the dividend yield of the S&P 500 Index last year was about 1.8%.  Assuming for a moment that this held true for the equity holdings in your Retirement Bucket, if you withdraw 4 to 5% of your Bucket each year to support your desired lifestyle, this means that almost half of your withdrawal come from dividends.

A great question you should know the answer to is what percentage of your annual Retirement Bucket withdrawals are supported by your dividends?  And, thus, how many more years of your anticipated withdrawals are substantially “immune” to short-term stock market corrections which dominate the news?

After I shared all of this with her, our Relaxing Retirement member asked, “so why does everyone make it sound like the end of the world when the market goes down?” 

Great question!  Two big, yet unfortunate, reasons:

  1. 24-hour news organizations do a fantastic job of scaring everyone to serve their own purposes. They perpetuate the myth that market price volatility is a bad thing when, in fact, it’s the source of long-term returns.
  2. They have no system for managing their money based on historical context, so they are forced to react emotionally vs. rationally to every piece of news.

Keep all of these points nearby so you can remain as confident as you deserve to be even when market prices are bouncing all over the place.

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)