Note from the CIO: Volatility is Not Risk

“Are you prepared for the next wave of volatility?”

“Market volatility bringing your clients’ portfolios down?”

These are the subject lines from just two of many unsolicited emails I receive in my role as the Chief Investment Officer at Abacus from investment vendors trying to tap into the prevalent fear and anxiety in the current environment. But what they may not be aware of is that at Abacus, we do not view volatility as risk.

The S&P 500 stock index started the year at 2,673.61. It continued its surge from 2017 through most of January, possibly buoyed by the reduction of the corporate tax rate, a key piece of the Tax Cuts and Jobs Act passed on December 22. The index high for the year so far, 2,853.53, was reached back on January 29, up 6.7% from the start of the year. We then experienced a correction when the index dropped 9.6% from its high to settle at 2,581.00 on February 8. After recovering most of the drop, the index fell again very nearly to the same low for the year on April 2. In a word, this is volatility.

Volatility is simply the measure of the up and down movements of the market. The more it feels like a roller coaster ride the more volatility we are experiencing. This random, up and down behavior of the stock market, particularly over the short-run (such as days, weeks and months) is largely driven by uncertainty about the economy and business outlook. In other words, volatility is synonymous with uncertainty.

Most of the volatility in the index this year appears to be from increased concern over potential economic damage if a trade war with China gets out of hand. In March, President Trump enacted tariffs on steel and aluminum, which prompted retaliatory tariffs by the Chinese that impact U.S. farmers in particular, to which President Trump threatened retaliatory tariffs of his own. One can imagine that China would consider further retaliating to those, and a trade war begins.

A tariff by a government on goods from other countries is a tax on its own citizens who want to buy those goods. For that reason, countless economists warn that tariffs are dangerous for the economy, and in 1930, 1,028 economists wrote a letter to President Hoover urging him to veto the Smoot-Hawley Tariff, arguing that it would “injure the great majority of our citizens”. Many economists and historians consider these tariffs a contributing factor to the Great Depression. Fortunately, Larry Kudlow, the new Director of the National Economic Council under President Trump, has a history of supporting free trade; however, he has recently defended Trump’s actions, not on economic grounds, but as a negotiation strategy. Well, we did finally ‘win’ the trade war that started in 1930, but it took until 1945 and cost millions of lives.

The question for investors today is why would anyone want to be invested in a market with the level of uncertainty and volatility that we have experienced thus far this year, and which may even get worse? After all, the range of 12-month returns has been historically wide, if not wild. Going back to World War II, the worst 12-months for the S&P 500 was March 1, 2008 through February 28, 2009 when the index dropped 43.3%, while the best 12-month period was July 1, 1982 through June 30, 1983 when the index gained 61.0%. By comparison, the historical worst drops of long-term bonds issued by the same kinds of companies have been less than half as severe (over periods such as 12 months, 3 years, 5 years, etc.). This reflects the fact that the bonds promise specific interest payments every year and they promise to pay the principle back at the maturity of the bond. That degree of certainty can be comforting.  Which tempts many to abandon stocks in times of volatility and head for the relative security of bonds.

The long-term historical annualized return in excess of inflation for these two asset classes has been a little over 7% for the S&P 500 stock index and 3% for the bonds. The 4% “premium” provided by equities relative to their more certain counterpart, bonds, may not sound like much. But let’s say you buy $100 of groceries per week (to use a round number). If you invest your money for 20 years in bonds earning 3% over inflation then you will be able to purchase $180 of groceries per week in today’s dollars, while the S&P 500 investment would allow you to purchase $390 of groceries per week – twice the purchasing power. By accepting uncertainty in the short-run, the stock investor captures a significant increase in purchasing power, or wealth, relative to more certain investments over longer periods of time. Volatility/uncertainty in the short-run is the cost of earning higher returns in the long-run, and the premium is the reward for accepting volatility/uncertainty. The two go hand in hand.

Over these longer periods of time, something else remarkable has occurred in the stock investment experience. As the chart below shows, the range of returns (from the worst to the best) has historically become more narrow, or certain, the longer the stock holding period.

For example, the worst 10-year holding period going back to WWII was -3.4% per year, while the best was 21.4%, which is a much more narrow range of outcomes than the 12-month period we already discussed. It is also worth noting in the chart that for holding periods over 10 years, the worst S&P 500 annual return was positive.

This turns the concept of “risk” upside down. Our emotional response to the market will always lead us to think that volatility is risk, even though declines in principle value have historically always been temporary and replaced by permanent gains. As financial planners at Abacus, we understand risk to be the possibility of having to lower your quality of living in the future. Historically the best suited asset class for managing this risk, as we showed above, is stocks. Yet even if volatility is a concern, the chart above shows that it decreases the longer you hold stocks. What matters is time in the market, not market timing.

As Leonardo da Vinci said, simplicity is the ultimate sophistication. Simplicity in investing is riding out equities’ temporary volatility in order to capture their premium long-term returns. This isn’t about “what’s working now.” This is about what’s always worked.

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