Tuesday, November 28, 2017

Volatility May Feel More Painful the Next Time Around

Stock and bond markets have been extraordinarily quiet since February 2016 lows. How quiet? A 60/40 portfolio consisting of the S&P 500 and the Bloomberg Barclays Aggregate Bond Index has a 12-month standard deviation of (wait for it)… 2.2% ending October 2017. This is the lowest period of volatility since the inception of the aggregate bond index back in 1976.

My own behavior has been impacted by just how boring markets have been, as I’ve slowly seen my own risk tolerance ramp up. In addition to thinking that I really need to rebalance, I’ve been thinking about the consequences of a world in which many investors haven’t experienced a material drawdown in many years / potentially in their entire investment lifetime. For those of us that are relatively young, even if we've lived through the 2000-01 dot com bust or the 2008-09 global financial crisis, it’s likely many of us haven’t experienced any material loss of wealth.

Viewing Market Volatility Through a $$ Lens

Let me explain with an example…. I graduated from college in May 2000, thus the below drawdowns are what I would have experienced in a 60/40 portfolio since I started my working career.

A well weathered investor I must be having faced two of the largest drawdowns in US history? Well... let’s take a look at this return history from a different perspective.

Rather than in percent terms, let’s look at the drawdown in dollar terms assuming an investor put $1000 in the market at time = 0 and added an incremental $1000 more than the previous year... each year (i.e. $1000 at time = 0, $2000 at T + 1, $3000 at T +3, etc…).

We can see from the above chart that the 2000-02 downturn may have seemed painful, but may as well not have existed in terms of consequence to an investor this early in their wealth accumulation (not to mention this investor was much less likely to have the stress of providing for a family). Even the 2008/09 downturn was quite minor in the grand scheme of things, matching the dollar drawdown of the tiny 5% drawdown experienced in late 2015. In addition, during the early stages of wealth accumulation, the ability for contributions to materially make up for market declines helps with the mental issue of otherwise seeing the value in your investment account fall (i.e. $10k is a huge contribution when your balance is $50k, $20k is much less so when your balance is $300k).

And where do many of us sit now?

For those of us fortunate to have accrued wealth over the last 10-20 years, we should anticipate a high likelihood of experiencing the largest dollar downturn of our lives at some point in the near future. In fact, in the scenario outlined above, a 15% drawdown from here would result in a loss ~4x larger than that experienced during the global financial crisis.

The implications to me are as follows:
  • Reevaluate your risk tolerance: not by the comfort level experienced over the past few years or even your entire investment life, but by what you should expect in the years to come given your current financial and life situations 
  • Create a game plan: for how you should / will react when market volatility “normalizes” (trend can be your friend)
  • Prepare for market volatility that doesn’t just “normalize”: but instead overshoots to the upside if / when markets do correct
We have a lot of market participants (myself included) that have never experienced any real turmoil and poor behavior always follows.

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