Market Volatility – What Investors Should Know

Key Points

• Markets have been unusually volatile so far in 2016, with plunging oil prices, slowing growth in China, steep declines in overseas equity markets, and concerns about Federal Reserve policy and a potential “Brexit” all contributing to uncertainty.
• While we have experienced a 10% U.S. stock market correction twice in the past year – and some pockets of the equity market (for instance, the NASDAQ) have done worse – it is not expected the current  correction to turn into a broad-based bear market.
• Investors should review their portfolios to make sure they still reflect their target asset allocations and goals. They should also resist the urge to buy and sell based solely on recent market movements, as it could negatively impact their performance over time.

Earlier this year Global stocks  have dipped into bear-market territory, as signs of a slowing Chinese economy, worries over European banks and tumbling commodity prices revived fears about weak global growth. The U.S. market had the worst start ever to a calendar year.

Understandably, investors often become nervous when markets are volatile, and we are hearing many questions from clients. Here are some of the most frequent ones, and our perspective:

What will it take to calm the markets?

Markets don’t like uncertainty, and there are a number of unknowns hanging over investors right now. For example: When will oil prices stabilize, and at what level? How quickly and by how much will the Chinese economy slow, and what impact will that have on other countries’ economies? What’s the outlook for the U.S. economy? Will we see heavy defaults by less-creditworthy companies? How will central banks  react to global conditions? Will the Federal Reserve  move too quickly, too slowly or just right in raising interest rates? What impact will a potential “Brexit” have on investments and the global market? Until these issues are resolved, we expect elevated volatility to continue.

Are we headed into a recession?

Economic forecasting is an imperfect exercise, but based on recent economic data, we don’t believe either the global or U.S. economies will fall into recession, although the risks have increased.

In the U.S., economic growth continues thanks to a healthy labor market, housing investment, more government spending and a strong services sector. While there are meaningful pockets of weakness in the real economy (for example, manufacturing) and market-based indicators (such as yield spreads, the shape of the yield curve and stock prices) are currently painting a dour picture, the bulk of the leading economic indicators are not at danger levels at the present time.

Will the correction in U.S. stocks turn into a bear market?

Through it all, its recommended that investors maintain an investment in stocks consistent with their appetite for risk and investing goals.

This view is driven by a few factors. First, if we’re right about the economy, we expect the recent price drops  will ultimately reflect a correction, not a longer-term bear market. Severe bear markets rarely happen without recessions.

Second, stock prices typically exhibit rich valuations just before big price drops, but valuations for U.S. equities are generally below historical median levels. However, we don’t see valuations expanding until earnings growth returns.

Finally, the U.S. market does not appear full of “hot money” – that is, funds moved around rapidly by investors seeking short-term profit – waiting to be pulled out of the market.

What should I do right now?

Every investor is different, but here are a few steps that everyone should consider, in our opinion.

•  Rebalance your portfolio as needed. Rebalancing is the act of selling positions that have become overweight in relation to the rest of your portfolio, and moving the proceeds to positions that have become underweight. It’s a good idea to do this periodically, because market changes can skew your allocation—over time, assets that have risen in value will account for more of your portfolio, while those that have fallen will account for less. The benefit of rebalancing is that it helps to keep your portfolio at a risk level that is consistent with your goals, potentially improving your returns over time as the market continues to change. Few investors enjoy volatility, but more volatile markets can increase the value of rebalancing.
• Understand what you own and map it to your goals. A cardinal sin of investing is taking on risks that don’t make sense – or no longer make sense – given your situation and life stage. If you haven’t looked at your portfolio recently to make sure you understand what each security and asset class is doing, now is an especially good time to become reacquainted with it. If you expect to spend from your portfolio within the next few years, consider holding assets that historically have been relatively liquid and less volatile than stocks, such as cash and short-term bonds. This can help you avoid having to sell in a down market.
• Resist the urge to buy or sell based solely on recent market movements. Successful investing is about the future, not the past. Our company and others have studied the behavior of investors in equity mutual funds, and compared individual investors’ returns to the returns of the funds themselves. In general, investors’ returns lagged the funds’ returns, largely because of herd mentality. Individual investors tend to jump in after the fund has done well and flee after it has underperformed. This doesn’t mean one should hold on blindly to declining investments, but it’s a good idea to take into account the investment’s future prospects and the role it plays in your portfolio.
• Know what you can stomach. Over the long term, a more aggressive allocation has historically reaped higher rewards in terms of returns, but there’s a dark side. Aggressive allocations have historically had a much wider range of returns. Investors achieve those higher returns through “stick-to-itiveness.” Many investors have learned the hard way that their tolerance for a big loss in the short term was less than they thought. A conservative allocation’s lower historical returns have generally come with significantly less drawdown (that is, price decline from a peak) and volatility. For some, it’s worth the lower expected return. But the reality is that many investors want all of the upside when markets are performing well – but none of the downside when they are not. That is highly unrealistic.
•  If you don’t have a target asset allocation, get one. We periodically discuss asset classes (for example, stocks or bonds) and whether we believe investors should be overweight or underweight the asset class relative to a target allocation. That kind of advice isn’t much help if you don’t have a target. Many investors don’t – but they should, as that is where strategic investing begins. In the course of setting a target, you’ll be forced to think about what amount of risk you’re comfortable with emotionally, how much risk you can afford to take, and when you expect to need the money for your goals, such as retirement spending or a child’s college education.

Bouts of market volatility are a normal, if sometimes unnerving, feature of long-term investing. As we consistently tell investors, the best way to weather the storm is to take the long view, select a portfolio that makes sense for your situation, stick to your plan and remember that this too shall pass.