Understand Stock Market Volatility
Short-term stock volatility is an unavoidable feature of financial markets. Reacting to it can be hazardous to your long-term retirement income.
What is Market Volatility?
Stock market volatility is the degree to which investment prices fluctuate over time. Stock prices can fluctuate for any or no reason, particularly over shorter periods such as days, weeks or months.
While investors often associate the word “volatility” with risk or loss, volatility can be both positive and negative. Every security’s price rises and falls over time. These movements may happen quickly or slowly depending on the security’s type, sector or issuing company.
In the short term, security prices can swing unpredictably and unnerve investors. But as you begin to look at longer periods, higher returns can reward investors who tolerate market volatility.
Higher or lower volatility is never permanent. It doesn’t predict returns or tell you what direction stocks will go next. Short-term volatility is one of the prices investors pay in order to participate in stocks’ long-term growth potential.
Historical Volatility
Historical volatility is a statistical measurement of stock price changes over a specific time period. Since 1928, stocks have been positive on a daily basis only around half of the time1 —effectively a coin flip. As the investing time frame increases, however, stocks have a higher likelihood of positive returns.
In periods of 10 years or longer, stocks are positive an overwhelming percentage of the time2. Individual years can vary greatly, but there’s no reliable pattern of above- or below-average volatility predicting annual returns.
Historical Volatility in Perspective
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Taking a longer view can help put daily volatility in perspective. One way to measure return variability is standard deviation, which represents the degree of fluctuations in historical returns.
Historically, over five-year time horizons, portfolios with more equity exposure in their asset allocation—the mix of stocks, bonds, cash and other securities in a portfolio—have a higher standard deviation than portfolios invested more heavily in fixed income. Over 30-year time horizons, though, the standard deviation of equity-heavy portfolios significantly decreases—it is even lower than that of more “conservative” fixed income allocations.3
The Risk of Reacting to Market Volatility
Uncertainty is a given in investing, but it can be uncomfortable to “sit by” and watch your portfolio fluctuate—whether through minor day-to-day ups and downs or big negative swings. However, volatility today tells you nothing about how volatile markets will be tomorrow.
Trading at the wrong time or failing to stick with your long-term strategy can lead to significant opportunity costs over time. If you attempt to sidestep regular negative volatility by jumping in and out of the market, you can face transaction costs and miss out on upswings.
Accidentally missing the best days in the market can cause cumulative returns over time to drop drastically. For example, over the 30-year period from 1988 through 2021, missing just the 10 best trading days would have cut your cumulative return by more than half.4
Volatility and Retirement Risks
Negative volatility early in retirement is often presumed to be the biggest risk retirees face. A common assumption is that negative volatility means each withdrawal you take is a higher percentage of your assets, increasing the risk you will run out of money. Each time the market experiences high volatility, personal finance websites pump out advice on how a new retiree should react to mitigate retirement risks.
Frequent suggestions include:
- Withdraw from the stock market and rely more heavily on Social Security or annuity payments for early retirement income
- Increase liquidity and carry a huge amount of cash
- Decrease equity exposure by moving more money into “low risk” asset classes
- Invest in target-date funds or another financial instrument that aims to dial back stock exposure over time
Myopic Loss Aversion
This type of advice is driven by myopic loss aversion—the human tendency to feel losses more than twice as much as we appreciate gains. This, combined with the belief that retirees should adopt a lower risk tolerance than younger investors, is rationalized into a “strategy.” But far from protecting you from future losses, making drastic changes to your retirement plan can contribute to retirement risks for long-term investors.
Longevity Risk
Reacting to volatility early in retirement can mean taking on longevity risk—the possibility that your actual lifespan will exceed expectancy projections. Nonagenarians (folks over 90) are the fastest-growing age demographic in America today. A 60-year-old American in good health can likely expect to live at least 20 years in retirement. Over that long span of time, volatility doesn’t pose much of a threat.
What does threaten your retirement is not earning enough money to fund your later years and still offset the impact of inflation or interest rates. Volatility-informed advice ignores why retirees own stocks in the first place: compound interest. A positive return earned early in your retirement is vastly more important to your retirement plan than a return earned later. It may be difficult to endure volatile periods early in retirement, but it is much worse to suffer late in life through failing to earn a sufficient return from your investment. You run the risk of outliving your money or having difficulty covering day-to-day costs of living, healthcare or long-term care expenses.
Remaining Disciplined
Volatile markets are uncomfortable and can be even more so for a new retiree. But early retirement is not the time to dial back equity exposure. A long-term asset investment strategy and a well-diversified portfolio are the best defenses against volatility, whether it is daily volatility, a correction, or a bear market.
An investor is well served to have a plan for bear markets. For example, you should know what your expenses are and how you can reduce them if needed. You should have an emergency fund. You should have a financial adviser who can help you weather investment uncertainty, bearish sentiment, price fluctuations and market swings.
Understanding how the market works is the first step in a good investment plan. As legendary investor Benjamin Graham put it, “The investor’s chief problem—and even his worst enemy—is likely to be himself.”
Volatility isn’t your enemy. It should never drive your investment decisions. Positive stock market returns are a result of volatility and are the reward for those who remain disciplined and focus on their long-term goals.
1 Global Financial Data, as of 1/22/2021.
2 Global Financial Data, as of 1/22/2021.
3 Global Financial Data, as of 11/10/2021.
4 FactSet, as of 2/15/2022.
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