Pay the Price

My latest column for Investment Advisor magazine is now available digitally. Since the accompanying charts could not be reproduced, I am posting the entire piece, with charts, here.

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Since the Great Financial Crisis, investors have been spoiled. From March 2009 through January 2018, the S&P 500 has returned 18.3 percent annualized. Moreover, despite high levels during the GFC and spikes in 2011 and 2015, volatility has been surprisingly low for much of the past 15 years. At the end of 2017, the S&P 500 One-Month Realized Volatility Index dipped under 6 percent. For investors, high returns and low volatility are a fantastic combination.

Such good times couldn’t roll forever. Volatility is back.

The S&P 500 One-Month Realized Volatility Index is above 20 percent as I write this column. That level isn’t remotely unusual or even all that high, but investors who had gotten spoiled by one-way traffic to higher prices are being spooked nonetheless. Anytime is a good time for a reminder of the fundamentals of market movements and the advent of volatility after a long absence is a particularly good time.

So repeat after me: Volatility is normal and necessary.

Especially during these sorts of transitional periods in the markets, I am regularly and invariably asked – longingly – for “the next Amazon.” The thinking is that if these investors could just smoke out the next great whatever company, all would be well and investing would be easy.

However, good investing is never easy. It is always hard.

Finding “the next Amazon” is really, really hard. As I have noted before, over 90 years (through 2015), 58 percent of all stocks underperformed one-month U.S. Treasury bills and most lost money over their lifetimes. The best performing 86 stocks accounted for over half the $32 trillion (with a “t”) in value generated by stocks over bills during that time while a mere four percent of stocks accounted for all the outperformance of stocks over bills. Finding any outperforming stock is a daunting challenge. Finding “the next Amazon” in advance is almost insanely difficult – perhaps impossible without some serious luck.

But let’s suppose for a moment that you could.

If you had invested just $10,000 in the Amazon IPO back in 1997, as of March 2018 – barely 20 years later – you would have nearly $8 million.

Source: Morningstar

Who wouldn’t love that! However, look at the drawdowns you would have had to endure to get those returns.

Source: Morningstar

How many of us could truly stomach a 90 percent drawdown and multiple 50 percenters? I’ll take the under. Even the best possible investments suffer huge (and thus terrifying) drawdowns. With (always 20:20) hindsight, it may not seem like too big a deal. We’re focusing on the current value today. However, in the moment, our loss aversion and our impulsive performance-chasing militate strongly against our being able to hold on when investments inevitably suffer losses.

The sad reality is that when market volatility seems oppressive, many investors bail. They say they simply cannot stomach the losses. That’s why the “behavior gap” between investment returns and investor returns is so huge and so potentially damaging. Many – probably most – investors who cash out when negative volatility rears its ugly head will see their chances of retirement success decrease significantly.

Annualized Returns as of 12/31/17: Stocks (S&P 500); Bonds (10-year U.S. Treasury Note); Cash (3-month U.S. Treasury Bill). Source: New York University

Stocks generally do not offer Amazon-level returns, of course. But the returns they do provide are very, very good indeed. Over the 30 years ending December 31, 2017, stocks (the S&P 500) returned 10.6 percent versus 6.4 percent for bonds (10-year U.S. Treasury notes) and 3.1 percent for cash (3-month U.S. Treasury bills). Everyone can see that the differences are significant, but it’s easy to miss just how significant they are. Over those 30 years, $10,000 in cash netted $24,728, bonds provided $65,123, while stocks earned $205,557. Avoiding stocks to avoid volatility¹ has an enormous cost.

Negative volatility hurts. Sometimes it hurts a lot. However, volatility is the necessary price paid for the much higher returns provided by stocks as compared with other investment choices. Investors would be wise willingly to pay-up.

 

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¹ Don’t forget both that (a) bonds had a fantastic run over this 30-year period, so the return gap will often be much wider; and (b) bond returns can have substantial volatility too.