5-Minute Huddle: Volatility Is Not Risk

Jan 24, 2021 | 5-Minute Huddle (blog), Economy, Investing, Risk Management

Justin Pawl, CFA, CAIA, CFP®

In this week’s edition:

  • Last Week Today. A summary of market-moving events.
  • Volatility. Risk or opportunity?
  • Capitalizing on Volatility.

Last Week Today. Former Federal Reserve Chair Janet Yellen was confirmed as Treasury Secretary, moving the two supposedly independent government organizations controlling the U.S. money supply ever closer to one another as the nation’s debt level exceeds 100% of GDP and moves higher daily. | Biden inaugurated as the 46th President and issues 15 executive orders targeting immigration, the environment, and the pandemic. | Not a lot of new economic data last week, but the handful of releases were positive as December housing starts rose 5.8%, and the December Markit manufacturing and service Purchasing Manager Indexes exceeded expectations.

Global equities rallied, and U.S. treasury bond yields ticked higher as investors attempt to find the right level in light of the contradictory deflationary forces of the pandemic and the inflationary impulse from fiscal stimulus. Compared to previous weeks, domestic stocks outperformed developed international equities, but China continued to build on its outperformance. One good thing about a communist government is the ability to squelch pandemics by authoritatively limiting citizens’ freedom. Even though it was ground zero for COVID-19, China reported Q4 growth of 6.5% and 2.3% for all of 2020. For detailed asset class performance over the last week and year-to-date, click on the table below.

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Volatility. Looking back, 2020 was a remarkable year. On the one hand, the COVID-19 virus took more than two million lives globally, forced thousands of business closures, and laid waste to the financial underpinnings of countless families. On the other hand, governments acted quickly to inject liquidity into markets and provide financial aid that ultimately left many households better off economically than before the pandemic and risk assets at all-time highs.

COVID’s effects and governments’ efforts worldwide to address it will be felt for decades. At the same time, 2020 offers a dramatic example of the importance of a disciplined investment strategy. Coming into 2020, markets had just completed an outstanding year that saw the MSCI All Country World Index (ACWI) gain 16.8% and the S&P 500 rise 18.3% (including dividends). Despite the length of the bull market and stretched equity valuations, stock markets continued to push further into record territory in 2020, bolstered by moderate global economic growth and central banks’ loose monetary policies. Indeed, in January, COVID was in the news, but equity markets were still setting new highs as late as mid-February 2020.

Then, in March, increasing infections and the World Health Organization declaring COVID a pandemic broke the old bull’s back. Global equities plunged -33% from their highs in less than five weeks as panic spread faster than the virus. Understandably, pessimism gripped investors’ psyche, driving stock prices down to levels that gave very little credit to human ingenuity to fight the virus or corporations’ ability to address declining demand effectively. Fearing the worst of outcomes, investors bolted, selling stocks and bonds in March and money-market fund assets swelled by $684 billion.

As investors rushed into cash, markets turned on a dime when the monetary and fiscal liquidity spigots switched on, and more data came to light about the lethality and spread of the virus. The S&P 500 jumped by more than 17.5% in just three trading days from the March 23rd low and would go on to rally nearly 30% by September 30th, making a significant down payment on a V-shaped recovery. Equities went on to complete the V-shaped recovery and set new highs registering impressive annual gains (ACWI +16.8%, S&P 500 +18.4%) despite an unbelievable turn of events.

Last year was an extreme example of why investors need an investment plan and adhere to it faithfully. At a minimum, the plan should consider the amount and investment time horizon for capital dedicated to equities. On a more advanced level, it should also consider how capital is allocated within equities to maximize returns over the expected investment horizon.

In determining an allocation to equities, one must acknowledge that volatility is an inherent stock market feature. The perception of volatility as risk is why equities exhibit the highest growth rate within traditional asset classes as equity investors are paid a higher “risk premium” than bonds, for example. In a diversified equity portfolio, volatility is not risk – selling equities at inopportune times is the risk as it permanently impairs one’s portfolio. The chart below offers a great illustration of historical equity market volatility. The gray bars represent S&P 500 calendar year-end performance since 1980, while the red dots show intra-year market declines. Every year equity markets experience declines, but equity markets still delivered positive calendar year returns 75% of the time.

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Source: JP Morgan

Recognizing that stocks are prone to extreme moves is critical because one of the most important contributors to compounding wealth is participating in the market during the best trading days. As we saw in 2020, selling in March would have been costly. Indeed, looking over a longer timeframe, various studies show that missing out on the top 10 trading days over long investment horizons cuts a portfolio’s value in half as compared to avoiding the temptation to sell when markets decline. That’s a significant difference, regardless of an investor’s overall wealth.

The bottom line is capital allocated to equities should not be considered for short-term needs. The longer one can leave money in equity markets, the greater the probability of growth. Research from AQR Capital Management illustrates this point. The probability of the S&P 500 outperforming cash increases with time:

  • Day: 51%
  • Month: 55%
  • Six months: 61%
  • One year: 66%
  • 10 years: 90%

A corollary is to avoid market timing. Market timing is challenging, even for professional investors, because it requires accurately making two correct decisions in a row: when to sell and when to buy. As March 2020 exemplified, getting only one of those decisions right is an expensive mistake for long-term wealth generation.

Another lesson from 2020 is that volatility creates opportunity and that investors should not approach markets with a “set it and forget it” strategy when it comes to portfolio allocations. When markets selloff like they did in March, valuations decline and reveal opportunities in stocks or sectors that were previously too expensive.

Capitalizing on Volatility. In addition to using market declines as an opportunity to find bargain stocks, an allocation to a strategy that benefits from rising volatility can accelerate the compounding of wealth. Above I cited an example of the negative wealth impact of missing out on the market’s best days. The other side of that coin is that missing out on the market’s worst days is hugely beneficial to equity portfolios. To illustrate this latter point, let’s consider the opposite of what would happen to a portfolio that missed the ten best performing days in the market. If an investor avoided the ten worst days in the market over the last 20 years, the portfolio would be worth more than twice that of a buy-and-hold strategy. That’s a substantial improvement over a buy-and-hold strategy.

If market timing is an ineffective approach to avoid large stock declines when investing in equities for the long term, what’s an investor to do? One approach is to embrace volatility as an asset class. Said differently, invest in strategies that benefit from the volatility that comes with stock selloffs. These “long volatility” strategies that act as a hedge to equity performance come in various forms. While no strategy is guaranteed to counteract poor stock market performance, the example of avoiding large losses is useful in illustrating how hedging strategies can lead to greater wealth creation. Moreover, by employing a cost-efficient hedging strategy that reliably reduces the probability of large losses, investors can allocate more to equities than they otherwise would in an unhedged portfolio. Covenant has allocated to long volatility strategies since its inception over 10 years ago, so if you have questions, please contact us.

In conclusion, equities remain the easiest asset class to access for the long-term compounding of wealth. Yet, investors must size the position appropriately, given their investment horizon. Effective hedging strategies can mitigate the risk of large losses, loosening the constraints of both sizing and the investment horizon for equity allocations.

My best,

Justin

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