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Building "Volatility Tolerance"

Saturday, February 14, 2015

by Sheila & Rich Jamison 

The market indices are at or near all-time highs. We came through some shaky periods over the last couple months … with an uncomfortable number of triple-digit down Dow days. There were periods that made people feel they should sell everything and head for the hills. Now, 6-8 weeks later, we’re all happy again. What’s going on?

Ideal vs. Real World

In an ideal world, investing would be both easy and simple. It would be comforting to believe we could adhere to a static allocation and annual rebalance approach and that such a strategy would steadily make progress towards our financial goals. You could think of it kind of like a bank making monthly interest payments to your savings account. Put our dollars in, sit back, enjoy the ride and wait as they regularly increased in value. We could withdraw money at any time without fear of loss.

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Reality

However, actual markets are very different. Asset classes go out of favor for years, and even decades, at a time. There can be spectacular stretches of capital gains and there can be excruciatingly painful periods of market losses. Real life investing (the real ride) looks more like this.

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Here’s how that went over the last 15 years for the S&P 500 Index, using the closing values and not counting dividends.*

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It’s obvious that the “smooth ride” theory has some holes. We’ll deal more with that and tactical allocation to help smooth the bumps in a forthcoming article. Right now, we want to address the nervousness that volatility can induce.

The biggest problem when volatility rises is that it can often cause people to buy or sell emotionally instead of rationally. Most emotional investing is poor investing. Great strides should be taken to avoid it.

Another way to say ‘keep your emotions in check’ is “ignore the daily news.” While each day’s headlines can be loud and bold, objectively strategy-based portfolios (like relative strength ones) can depend upon the contribution of “uncomfortably” long leadership trends to provide the outlier returns.

What about the Volatility?

Here’s where the ‘rubber meets the road’ as it concerns the most recent few months. This is what the last 3 months S&P 500 chart looks like

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While this looks a bit scary when observed for this 3-month period, note that the high to low is only about 5%. These are within ‘normal’ or ‘expected’ variations based on historical data.

Still, the feeling of reversing up from a short-term low only to drop back down again several times is uncomfortable at best … and can be panic inducing at worst. In hindsight it’s obvious we are ahead of the value in early December. We have gained by staying invested. But panic often leads to more than selling. It can lead to creation of a strong reluctance to re-invest … often until a significant amount of the next upward move has been missed.

So how can we keep emotion out of the investment decision process? Look at the 6-month chart

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Note that the most recent 2-month bounces (right third of chart) don’t look as severe from this perspective. They are quite a bit less than (actually about half of) last summer’s 10% pullback.

Remembering this image can help keep those emotions in check the next time we hit some of the smaller bumps in the road. But it introduces a “should I panic at the 10% bumps?” question.

The first answer to that question is you should never panic. Clear analytical thinking is impossible in a panic mode.

For the second answer to that question, look now at the last 10 years.

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During this overall long-term rise, you’ll immediately note the financial crisis and a better than 50% drop. You can see other drops of 10%+ also. But note the little 10 percenter from last summer is the last noticeable decline. The ups and downs over the last 3 months look even less meaningful than they did in the 6-month chart as they almost disappear completely from the 10-year perspective. Keep this chart in mind along with the other ones as it too will help keep those emotions in check as you go along.

It Takes Practice

All this may take a little while to really sink in. Looking back over the three S&P charts may help drive home the point that all dips look bad as you start down into them. Some will be bad. Others will not. They will be merely speed bumps.

But the human mind is programmed for fight or flight when it perceives a threat. Notice that is “perceives” a threat. We once encountered a hiker in a frozen state because he saw a large snake just off the trail. He backed off to the mountainside edge of the trail and was afraid to move – cliff on one side and snake on the other.

Our pulling some tall grass and bushes aside (cautiously) for a more careful look revealed the perceived ‘snake’ actually to be a large fallen tree limb. Hard to be rational when panic sets in. By the way, we weren’t being heroic. We needed to discover if there was really a snake there or not. More important, if it was there we needed to discover whether it was a dangerous (venomous) snake or a ‘just walk on by’ snake as we were trying to pass that same point.

This applies to volatility and investing too. The trick to growing tolerant of these bumps is the realization that they can all feel the same after just a bad week or two. But they aren’t all the same. Most are not ‘snakes’ and pass without incident.

How Do You Know the Bad Ones Going In?

The uncomfortable answer is you don’t. You can’t. But it’s a bit like getting a closer look at that potential snake. The best way we can do this is to fall back on a discipline that relies on numbers rather than emotions. Even that will not be right all the time … but historically; it has a pretty good track record.

It takes time to get the emotions out of investing. It takes practice and experience to grow tolerant – maybe even comfortable – with volatility. Being here to help you do that is a large part of why we’re here at all.

*It’s not possible to invest in the index itself. If we wanted that broad market exposure, we would have to buy all the stocks that make up the index in the right proportion, or buy an ETF or mutual fund that mimics the index’ performance as best it can. But let’s use the index as a surrogate for the market for ease of illustration.

Source:

Charts derived from Yahoo Finance data and graphing at finance.yahoo.com on February 14, 2015.
The data above were taken from sources deemed reliable. However no guarantee can be made as to their completeness and accuracy.
Interpretations of the data, views and/or opinions expressed are those of the Jamison Financial Group based on market and economic conditions as of the date of publication and are subject to change. They do not necessarily reflect the opinions of any other individual, group or organization.
Nothing in the above is meant to be, nor should it be construed as, investment advice or recommendations to buy or sell any security. Individual securities whenever mentioned are for illustrative purposes only and may not be relied upon as investment advice.
Tax and/or legal information contained herein is general in nature and for informational purposes only. It should not be relied upon as advice. Consult your tax professional or attorney regarding your unique situation.
All indices are unmanaged and are not illustrative of any particular investment. A direct investment cannot be made in any index.
The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks.
The NASDAQ Composite is a market-weighted index of all the over-the-counter common stocks traded on the NASDAQ system.|The S&P 500® is a market-capitalization-weighted index of common stocks.
Past performance is no guarantee of future results.

© 2015 Jamison Financial Group. Please feel free to distribute copies to individuals you feel may benefit from the information presented. Commercial use is prohibited.