Year In Review And Investor Behavior
To say that 2017 was an unusual year in the stock market is an understatement.
Certain financial measurements make this clear. For example, Standard Deviation is a measure of volatility. The lower the Standard Deviation, the less volatile that asset is. The Sharpe Ratio is a metric used to calculate “Risk Adjusted Returns”. The higher the Sharpe Ratio, the better, as that equates to higher returns relative to the risk. Assessing each of these metrics relative to its history gives insight into how low volatility was in 2017.
In the past 20 years, the average Standard Deviation is 13.3%; in the last decade, it was 15.1%. In 2017, Standard Deviation was 3.9%. In other words, the S&P 500 was 75% less volatile in 2017 than in the past decade!
In the 20th Century, the Sharpe Ratio was above 2.00 only five times. The previous high was in 1954 when it was 2.60, and the past ten year average is .45. In 2017, the Sharpe Ratio was 4.40! That may not seem like a big difference from the previous high of 2.60, but in terms of percentages, it’s 70% higher. Almost ten times higher than the ten year average of .45.
In hindsight, 2017 was an ideal year for investors. Stocks went up slowly, without any significant pullbacks. Who wouldn’t want that every year?
People should not expect 2017 to repeat and should understand how unique 2017 was. When the S&P 500 index is viewed through metrics such as Standard Deviation (risk) and the Sharpe Ratio (Risk Adjusted Returns), 2017 was probably a once in a lifetime type of event.
Volatility has increased in 2018. Is this a reason to be concerned? Not at all.
Volatility is a normal function when investing in stocks. Historically, a stock market correction (defined as a decline of 10%) occurs once a year. A “bear market” is defined as a pullback of 20%, and happens on average once every 3.5 years. These events happen frequently enough that when they occur, investors should not panic.
What should they do?
1) Keep a long-term perspective. If investing for long term growth, don’t stress about daily, weekly or monthly movements. Keep returns in perspective. For example, between
January 22nd and February 5th of this year, stocks declined 10%. However, the past five years the price of the S&P 500 has increased 74% (from 1551 to 2691). When viewed in this context, a 10% pullback to 2581 doesn’t seem so bad.
2) TV and Social Media are entertainment. For example, I enjoy watching CNBC as much as anybody, but it’s entertainment. Don’t let the talking heads get you worked up. Don’t take investment advice from somebody on TV who doesn’t know you or your risk/return objectives. Anchors and commentators on CNBC, Fox Business, or Bloomberg want higher ratings. Therefore, news will be sensationalized.
3) Make sure your portfolio is aligned with your risk tolerance. If you aren’t comfortable with a 30% temporary decline in your portfolio, why are you invested 90% in stocks? Consult with a Financial Advisor to ensure your portfolio is balanced between stocks/bonds and alternative investments. One of the worst things an investor can do is capitulate when stocks decline, sell, and then try to buy in at a lower point. This rarely works, and most of the time you will buy back into the market at a higher price than when you sold.
Expect volatility to increase moving forward. However, this should not be a cause for concern but accepted as a return to the norm. Cash continues to yield a very low return, usually well below inflation. Historically, a portfolio of stocks and bonds will generate returns well above inflation. Combining different Alternative Investments into some investor’s portfolios is used to create an additional layer of diversification. Keeping a long- term perspective while staying invested in a balanced portfolio is simply the best path moving forward.
Philip B. Snyder, CFA