Four Fundaments to Navigating Volatility

It has been difficult watching the markets the past five months. 2022 has had one of the most turbulent starts to the trading year, and this was compounded by the worst month of April in the last 50 years. It is completely normal to be afraid for our investments, keeping perspective can be difficult and all too often investors consider selling off investments during downturns. However, selling assets to move into cash often hurts investment returns long term.

There is no one cause of the recent market turmoil. Continuing COVID-19 shutdowns in China further disrupting the supply chain, inflation at the highest level in 40 years and central banks raising interest rates aggressively as a response, the market rotation with many technology and lock-down related stocks coming under pressure, and the invasion of Ukraine and growing tensions between NATO and Russia have all added to investor uncertainty. Each of the above brings unique knock-on risks into the market, but there are also many reasons to be optimistic. For example, corporate earnings and employment numbers are still strong, and with current prices down many quality stocks are starting to look much more reasonably priced for long-term growth. Where the market was clearly overbought following the recovery from 2020, the recent pullback has also created opportunities in the market where good companies have sold off along with the greater market. It is these times where active fund management earns its reputation.

We do fully recognize that for many individuals these times are the most difficult to actively invest. The Nasdaq has already entered bear market territory, and it seems likely that the S&P 500 could follow very soon. Therefore, we thought it might be timely to offer our top four tips for investing through bear markets.

Invest for the long term.

Investing is a long-term endeavour; while rough patches are normal, the general direction of the markets is up over time. The market normally goes through down periods from time to time, but it is important to remember that no matter how low the lows, eventually the market will recover to new highs. To underscore this point, have a look at the graph below (Fig. 1.) comparing four different market investment types over the past 40 years, a rough estimate of how much time many will spend saving for retirement. Despite five separate recessions over this time, encompassing both the Great Recession of 2008 and the fastest correction on record in the COVID-19 pandemic, the general trend of both the Toronto Stock Exchange index (S&P/TSX) and the S&P 500 are up over time. Furthermore, both the S&P 500 and the TSX increased substantially more than a ‘safe and secure’ investment such as a rotating 5-year GIC investment. In the middle is the Morningstar Canadian Fixed Income index, with more volatility but greater yield than a GIC, and less volatility but lower return that the stock indices.

Investing is an emotional roller coaster – don’t give in to fear.

If there is one thing that we all have in common when it comes to investing, it’s that we all suffer from fear at times. Investing can truly be a wild ride, but we need to be cognizant that our emotions often lead us to make mistakes. In good times it is easy to fall into a false sense of security and feel as though we can do no wrong. This sense of euphoria often drives us to invest even when the market gets overvalued because we expect the good times to keep on rolling.

However, as humans the loss we feel on the downside tends to be twice as impactful, a quirk of our psychology called loss aversion. This means that as the market continues downward, we often become despondent, which can lead to panic as we expect the market to keep declining. Panic commonly causes investors to sell out of their investments at the worst possible moment. For example, a disproportionate amount of money was taken out of investment funds at the market bottom in 2008, and as the market was already recovering during the corrections of 2016 and 2018 (based on proprietary data from Manulife Investments). It is therefore essential to trust the long-term plan we have in place, a plan that accounts for market pullbacks, when you begin feeling nervous, and resist the urge to sell out of fear.

Time in, not timing the market is important for long term performance.

There is a common refrain that missing the ten best days in the market will lead to a drastic reduction in performance. While mathematically this is true, it is not necessarily a realistic scenario, in that if you were sitting in cash you would not only miss the ten best days, you would miss a lot of bad ones too. However, the sentiment behind the thought is true: those that sell when markets are down will inevitably miss the best days in the market. For example, two of the top ten largest one-day gains (by percentage) in the S&P500 happened on October 13^th, and October 28^th of 2008, in the depths of the Financial Crises. Two more of the top ten occurred March 13^th and March 24^th of 2020, during the COVID-19 crash.

Detractors of this sentiment will argue that the best or worst days are irrelevant if you miss a large portion of the down, even if you miss some of the up as well. However, I have yet to see anyone accurately call, in real time, the market bottom or how much further the market has left to fall. For example, most analysts were warning of a bear market rally in 2020, where the market would have a ‘W’ shaped curve; in other words there would be a recovery after the initial drop, and then another big down swing before finally recovering. However, this second leg down never materialized and had you waited on the sidelines you would have missed the entire recovery. The market is unpredictable, even the best prognosticators seem to get it wrong as much as they get it right, but as we spoke about earlier, the only thing we know for certain is that the general trend of the market is upward over time.

Take advantage of long-term market opportunities.

The problem with market corrections and recessions is that despite a lot of effort being placed into identifying predictors, no one can accurately call when a correction is going to begin, or when one will end. Bull markets (ie. market gains) can run on much longer that many doomsayers predict, and bear market routs can deepen further than analysts expect. Additionally, even very bad corrections can sometimes recover faster than anyone thought possible; 2020 was the steepest decline in history, yet the US recession lasted only two months. The bottom line here is that we just don’t know what is going to happen tomorrow, next week, or next month.

Instead, let’s focus on what we do know. We know that sooner or later the market will recover any declines seen during corrections. With this in mind, what should we do when the market corrects? Lets look at an example from the financial crises of 2008. Consider an individual that invested $10,000 in a US index fund on January 1^st, 2007. By October 3^rd, 2008 that money would have declined to roughly $7,394, a little bit more than a 25%. That individual then got nervous with the market losses and after much consideration, came up with four possible courses of action:

a) stay invested and ride out the volatility,

b) give in to the fear and sell all investments, going 100% to cash,

c) invest a small amount every month to take advantage of the markets being down, or

d) invest a lump sum in an attempt to capitalize on decreased stock prices.

I should emphasize that in real time this individual would have no way of knowing that the market would fall another 15-20% and not actually reach bottom for a further five months.

As you can see from the graph above (Fig. 4), although the markets were destined to fall considerably more before the correction was over, with a long time horizon, the best outcome is obtained by investing a lump sum to take advantage of the oversold market. Admittedly, it can be difficult to invest a large sum when the markets are down, so for the more conservative investor, dividing the sum over ten months will also give an added benefit. The bottom line is that focusing on your time horizon is key, if you expect to need your money in the next 6-12 months, sheltering in cash is safe, but for those that do not anticipate needing their investment for 2 years or more, the right answer may be to simply stay invested and trust their plan.

Summary

Investing is hard, there is no doubt about it. The most difficult part of investing your hard-earned money is not the act of picking assets, it is managing fear and anxiety through market volatility. We know how difficult it can be to not do anything while hearing all the negative news on tv, radio or the internet, and watching your investments decline. Or, more difficult still to add money into investments which seem to be going down day by day; this can feel as though you are throwing good money after bad. But more often than not this is the best and most pertinent course of action.

If I could leave you, our clients, with one message it would be this, we have worked together with you to create a plan around your expected time horizon, risk comfortability and future goals. This plan also takes into account some market variability and the inevitable recession. Try to trust in the plan. By focusing on good funds that invest in quality companies, history has shown that the market will recover if given enough time. But between now and then, try to remember: when it comes to investing in mutual funds, what goes down typically comes back up…let’s just hope it is sooner rather than later!