How to Stomach Market Volatility
This has been quite a few weeks in markets all over the world with huge daily price swings and the net result of official entry into bear market territory.
As I’ve shared on many occasions, declines of this magnitude are fairly common occurrences with the average annual intra-year peak to trough drawdown of 14% since 1980.
However, such a decline in a few short weeks is noteworthy, not for its depth but for its suddenness.
Markets hate uncertainty and there is a lot of that to go around right now in the news.
We have no control over the uncertainty, but we can and should have perfect control over how we respond to it.
Given this, here is my play book for how I recommend you “stomach” this market volatility.
Before we jump into the nuts and bolts of it, I thought I’d quickly share Vanguard founder John Bogle’s great response again 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 most important component of the play book I recommend is to 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.
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.
Effectively dealing with heavy doses of market volatility begins with completely de-emotionalizing yourself, so let’s begin with some facts 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 60-year old couple is 30.9 years, to age 91. For a 70-year-old couple, it’s 21.8 years and age 91.8. 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 rise. 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 74 years since World War II, the value of the S&P 500 Index, our general proxy for “the market”, grew in price from 13.49 to 3,230 at year end before retreating to where it is today, or more than 239 times in value! (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 and prior to this most recent dip, there have been 93 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 overly 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:
- Prices move wildly and randomly on a daily basis.
- There is a bell-shaped distribution of returns with a very large percentage of daily returns falling within a very small, concentrated range.
- 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.
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 Game Plan toolbox to “stomach” market volatility and remain confident is to play the higher probability percentages of owning a globally diversified portfolio using low cost index funds which are built to capture the expected returns of various asset classes in a cost-efficient manner.
By strategically diversifying your holdings in this manner, you position yourself to not only capture the long-term 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.
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 likely withdrawing (or approaching the point where you will be withdrawing) funds from your Retirement Bucket™ of investments each month to support your desired 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 investors make at this unique stage in their lives 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. Our average member withdraws 0.25% on a monthly basis. 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 stocks, you buy yourself time….time to hang in there with your equity holdings long enough (without panic selling during temporary market corrections like this) to capture long-term returns!
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 like this 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 1945-2019, 33.27% of the total return of the S&P 500 Index came from dividends. 66.73% came from price appreciation which is the only measurement typically reported.
- While CPI inflation has averaged less than 3% per year since 1990, dividends grew by 6.09% per year, 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 1.85%. Assuming for a moment that this held true for the equity holdings in your Retirement Bucket, if you withdraw 4% 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?
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.