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June 01, 2009

Volatility? It's Even More Than You Might Think
by Tom Madell

Many investors appear to have reacted with complete surprise and near disbelief to the huge drop in the value of their stock funds between Oct. 2007 and March of this year. As you are surely aware, losses in value from the highs, which were at a record level, to the lows, were typically around 60% over a wide range of stock funds. (As of 5-30-09, the losses in the S&P 500 Index have been trimmed to about 40%). Individuals so affected might have felt that losses such as this "just weren't supposed to happen."

But when we look back over the history of the stock market's up and downs, you will see that extreme multi-year volatility has always been part and parcel of stock investing.

If you protest by saying there have hardly been such extreme drops since the Great Depression, remember that volatility refers not only to drops in stock prices but also to large gains. And, whenever the stock market goes up a great deal, there is no reason why it can't come down a great deal as well.

A look at the following table shows that extreme downs and ups happen frequently enough that they are likely to impact most investors every few years.

Bull markets rallies can occur within secular (very long) bear markets; likewise, bear markets can occur in on-going longer-trend bull markets. These reversals are included in the above table. Without them, some bear/bull markets would appear as even greater losses/gains, such as during the 2000-2002 time period when the S&P 500 dropped a total of 49.1% from top to bottom, even though the table shows the period as two less severe bear markets with a bull sandwiched in-between.

As you can see, a downward or upward change of 20% or more (or nearly so) happens relatively frequently. So, since 1946, there have been 30 major changes of direction, occurring on average every 2.1 years. These changes eventually lead to some pretty big gains or losses. While the gains have been bigger than the losses, if we just look at the absolute size of the change, you can see that the 51.9% loss suffered recently beginning in Oct. 2007 (and -56.8% if measured through March) is about in line with the average losses or gains during the 30 periods of change.

The bottom line? Investors in the stock market need to be aware of the extremely volatile nature of the stock market. While the very long-term trend of the market has always been positive, getting through any period of time less than 5 to 10 years years has always been fraught with danger. There is frequently the possibility of a big drop. Not only that, there is no rule of investor safety saying that if the market gained 100 or more percent as in did between 2002 and 2007, that it can't give up such gains, and even more so in a subsequent bear market. This is what happened recently and has happened before.

Given such volatility, any investor must accept the fact the such risks are ever-present. It is to ignore history to assume that one can be invested in the market and be able to skate free of these dangers. Thus, unless you are a trader, you always need to be able to stay at least 5 to 10 years in your stock investments, if necessary, to be reasonably assured of not suffering from the worst bear markets can dish up.

And, as my free Newsletter has always stressed, you should always be more willing to invest in the market when valuations are relatively low vs. when they are relatively high.

When you put money to work in the market makes a big difference. You can't just assume that any time is a good time; you should be extremely patient, waiting as long as necessary for periods of market underperformance before investing more. We also believe that once it appears that the market, or pockets within it, are too highly valued, you should be willing to take profits, seek out areas of under-valuation, or even retreat to alternative investments such as bonds.

Looking at the big picture, we think that stocks in general are closer to being under-valued than they are over-valued. Or, put otherwise, if you were willing to invest more (or remain fully invested in stocks) during the years 2005 through late 2007, you shouldn't have nearly as many qualms about doing so now as you might have had back then.

Tom Madell, Ph.D.
Publisher
Mutual Fund Research Newsletter

Mutual Fund Research Newsletter is a free newsletter which began publication in 1999. It has become one of the most popular mutual fund newsletters on the Internet, ranking number 7 on the Google Directory page for Mutual Funds News and Media Newsletter websites. Since we began publishing our quarterly Model Portfolios, 29 out of the 36 Stock Portfolios have outperformed the S&P 500 Index over the following year (data as of Sept., 2009). Since 2000, 28 of our Model Stock Portfolios have had the opportunity for at least 3 years to pass since we first published it. 25 out of 28 of these Model Stock Portfolios have outperformed the S&P 500 Index over the following 3 years, and ALL Stock Portfolios (20 out of 20) have outperformed over 5 years as well. Mean level of outperformance has ranged from about 3% over 1 year to over 4% PER YEAR over 5 years.

Copyright © 2003-2009 Tom Madell

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