Why Everyone's Talking About… Market Volatility

It’s important to put things in context. The recent bout of volatility has been especially bad as central banks play catch-up to try to tame ballooning inflation, hurting both stocks and bonds. But bear markets are a normal part of the business cycle.

In the last 140 years, in fact, there’s been 19 stock bear markets, with an average decline of around 37%.⁶ Such downturns tend to be tamer outside of recessions, with falls around 20%.⁷ If inflation moderates and we do avoid recession, the worst may already be behind us – especially since most of the sell-off has happened as a result of rising rates (the ‘P’), rather than cratering profits (the ‘E’).

In addition, most bear markets are over relatively quickly anyway, with losses eventually recouped: S&P 500 bear markets tend to last around a year, with investors breaking even after just over two.⁸ And the recent turmoil comes after a truly epic bull run: even if the most bearish calls of 3400 on the S&P 500 are realised, that would still only take us back to late 2019, just before the pandemic hit.⁹

For those that have been invested for years, 2022 could prove another blip like 2008, 2018 or 2020.

And no matter how scary things seem, investors can find comfort in the fact that stocks usually prove more resilient than they suppose, rising steadily over time – despite various wars, pandemics, natural disasters, financial meltdowns, monetary resets, and recessions. Even the great inflation shock of the 1970s, which saw inflation peak at 14% and stocks tread water for over a decade, was eventually followed by one of the greatest bull markets of all time in the 1980s.¹⁰

For long-term investors, the best course of action may actually be to do nothing. When things go awry there’s a tendency (called action bias) to want to do something – anything – to fix things or take control. Too often this results in missing the rebound, being underinvested for long periods, or deviating from one’s investment plan. It’s an easy way to underperform over the long run, as investors lock in losses now only to miss the rebound later.

Would-be investors, meanwhile, may even see the extreme pessimism as an opportunity; as Warren Buffet famously said, ‘the trick is to be fearful when others are greedy, and greedy when others are fearful.’ That certainly rings true now. Picking turning points is notoriously difficult, if not impossible, but putting money to work when there’s ‘blood on the streets’ has shown to work time and time and again. It’s no surprise the Oracle of Omaha himself is dipping his toes into this market and adding positions after sitting on a mountain of cash for years.

Yes, the first half of 2022 has been historically bad for investors. Yet history also shows that these times pass. Panicking or extrapolating current woes into the future ad finitum is a fool’s errand.

Too often, investors become their own worst enemy. In a shocking 2020 report, research firm Dalbar found that while the S&P 500 averaged 6.06% per year between 1999 and 2019, the average equity fund investor earned just 4.25%.¹¹ That may sound paltry, but over 20 years a near 2% annual difference can have a dramatic effect. And the culprit, they said, was people’s emotions.

“One major reason that investor returns are considerably lower than index returns has been the fact that many investors withdraw their investments during periods of market crises,” they wrote. “Since 1984, approximately 70% of this underperformance occurred during only ten key periods. All of these massive withdrawals took place after a severe market decline.”

Perhaps this is to be expected. Human beings, after all, are emotional creatures, and very few of us can remain unaffected by the animal spirits of fear and greed – forces that dominate markets. However, the more we overestimate our ability to time markets or act on impulse or emotion, the less likely we’ll succeed in meeting our goals.

“Your money is like a bar of soap,” famed economist Gene Fama Jr. once said. “The more you handle it, the less you’ll have.”¹²

Instead, staying the course and doing nothing should be thought of as a conscious decision. If you’ve got a long-term plan or professional adviser guiding you, then short-term sentiment and market swings simply shouldn’t matter. It’s developing a plan – and, most crucially, sticking to it – that gives investors the greatest chance of compounding returns, even if it can feel uncomfortable at times.

“Typically… [those with little composure] give up long-term performance to seek short-term comfort,” explained Greg Davies, head of behavioural science at Oxford Risk. “People say, ‘They’ll sit on the side until I’m comfortable again’ – but you won’t feel comfortable until well after the fact.”¹³

For everyone that has timed the market and won, there’s plenty more who have missed the rebound and lost out – as the rapid bouncebacks in 2018 and 2020 showed.

Could the recent sell-off actually represent a buying opportunity? Although it’s impossible to know if a new bull market beckons, things are starting to look interesting once more.

Between the start of April and mid-May, stocks experienced seven weeks in a row of near continuous selling, the second longest period on record going back to 1928.¹⁴ That’s seen stocks in Europe and China dip below their long-term average valuations, and the US stock market just slightly above its 10-year average forward price-to-earnings ratio (at late May). Finally, it seems, the risk-reward is beginning to brighten.

Just as important is the extreme pessimism now pervading markets. Fund managers are holding the most amount of cash for 20 years – a huge sign of trepidation – and survey and sentiment indicators, such as Fear and Greed polls, are so bad they’re screaming ‘buy’.¹⁵

This doesn’t mean a bottom or rally has to happen, though historically it’s paid to invest when sentiment is extremely poor. But it’s notable that shrewd investors like Warren Buffet are beginning to put money to work and, in another optimistic sign for investors, corporate insiders are finally starting to purchase their own stock.¹⁶

That’s good for a couple of reasons.

First, it shows that insiders now think their own companies are cheap or offer compelling long-term value going forward. And second, insiders are often considered the ‘smart money’ that know their business, and its prospects, inside out; it pays to invest alongside them when you can. Conversely, the record number of insider sales when stocks hit their highs in 2021 should have come as a warning sign.¹⁷

For those that can temper their emotions, adopt a long-term timeframe, and go against the grain, dollar cost averaging now may seem an astute strategy. If things do get worse, losses are kept to a minimum, and you can buy assets at cheaper prices in the future without trying to time the market.

Ultimately, it’s important to keep perspective – especially during difficult times like 2022. Resisting the urge to do something is often crucial. History shows it’s investors, not markets, that are their own worst enemy.