Volatility — is it here to stay?

Volatility — is it here to stay?

In 2010, most stock market experts predicted a relatively modest year following a calamitous 2008 and a dramatic recovery in 2009. While the S&P 500 stock index is up around 4% year-to-date as we near the end of September, the ride has been anything but smooth in producing these relatively moderate return results. In the paragraphs that follow, I will illustrate the impact of volatility on a portfolio and offer our rationale for why Oak Wealth Advisors believes we will have volatile markets for the foreseeable future.

In 2010, most stock market experts predicted a relatively modest year following a calamitous 2008 and a dramatic recovery in 2009. While the S&P 500 stock index is up around 4% year-to-date as we near the end of September, the ride has been anything but smooth in producing these relatively moderate return results. In the paragraphs that follow, I will illustrate the impact of volatility on a portfolio and offer our rationale for why Oak Wealth Advisors believes we will have volatile markets for the foreseeable future.

When 0% is not 0%.

Marketers of investment products that have high volatility (i.e. returns that swing much higher or lower than the market averages) often ignore the impact of their product’s volatility on the wealth of the investor. They will advertise that over a 10-year period their average return is one or two percent better than the market. At face value, that is a compelling argument to invest in their product. However, you have to consider the impact of the volatility of the returns.

As can be seen in the below illustration, average returns do not tell the whole story. In fact, if the return pattern experienced by Portfolio #1 were to persist for a decade, the ending value would be less than 1/4th of initial $100,000 value. Volatility, if left unchecked, can do significant damage to a portfolio.

2010 volatility has exceeded all expectations.

In the midst of a recession or during the rebound off the bottom of a recession, volatility is to be expected. In the year following the recovery from the bottom of the recession, less volatility should be anticipated assuming no major crises arise in the political or economic arenas. In 2010, the biggest market concern has been the weakness of some European economies. While not ignoring the sovereign risks that arose this year, in general, 2010 has been a relatively uneventful year in terms of crises impacting the investment markets.

Therefore, we should have experienced very little volatility in 2010, right? Actually, we had the worst stock market performance for a month of May in seventy years. The worst month of August returns in a decade has been followed by the best month of September returns in seventy years. These record-setting months have been more volatile than the May, August, and Septembers in the middle of prior recessions or major crises!

Our government claims to have decreased the uncertainty and improved the oversight in the investment markets with its recent financial legislation. The near-term results do not reflect their claims.

 

Impact on a $100,000 Portfolio

Diversification matters!

After the recession of 2007-2009 (it officially ended in June 2009) there was much press declaring the death of diversification because seemingly all equity investments fell dramatically. While most stocks did tumble, proper diversification means holding investments other than stocks including investments in a variety of bonds and some alternative asset classes like real estate and commodities. In the last recession, for diversification to have benefited an investor, the bond allocation had to have a heavy dose of U.S. Treasury bonds.

This year, traditional diversification has worked wonderfully. Municipal bonds, corporate bonds, and even TIPS which got off to a sluggish start, have produced very attractive returns. Real estate, in the form of REITS, and gold have been the best performing asset classes. Stocks, while advancing moderately through the first three quarters of the year, have done so in dizzying fashion.

With technology advances growing exponentially, the ability for institutional traders to exploit minor opportunities continues to increase. The technology improvements also make information available instantly. Instead of gradual data dissemination and patience in analyzing and reacting to it, news is now acted upon instantaneously. The immediacy of action contributes to the volatility and there are no signs that the speed of technology is going to slow in the future.

How can individual investors minimize the impact of volatility?

Three simple rules can help individual investors minimize the negative impact of volatility. First, avoid being a stock picker or an owner of large positions in single stocks. This is not your father’s stock market and owning GE, IBM, and Exxon is no longer a safe path to financial security. Second, do not have more exposure to stocks in your portfolio than is necessary to meet your goals and achieve a proper level of diversification. Third, expand the variety of low-cost, tax-efficient investments in your portfolio. Greater diversification is perhaps the only “free lunch” remaining in the investment world. Volatility is best reduced by greater diversification and less volatility leads to greater wealth creation.

This update is intended for the use of Oak Wealth Advisors LLC clients. This update should not be viewed as personalized investment or financial planning advice from Oak Wealth Advisors LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to their individual situation, they are encouraged to consult Oak Wealth Advisors LLC. Past performance does not guarantee future results and all investments should be scrutinized before being implemented in a portfolio.