What? Stock Prices can be Volatile?
By TCV’s Trust Investment Committee
As the historically calm 2017 fades into memory, stock market volatility has emerged suddenly as the fear of rising inflation gripped investors. A stronger- than-expected increase in U.S. hourly wages reported in early February sparked a sell-off in equities. As stocks sank, the CBOE Volatility Index (VIX), a measure of market volatility, experienced its largest one-day increase in the index’s history. Adding fuel to the selling fire was the unwinding of exchange-traded products that bet against such a move in the index. The volatility kept investors on edge for most of February, and by month’s end the S&P 500 recorded its first monthly decline in more than a year. The selling was not confined to the U.S. equity markets either, as both developed and emerging international markets were down more than 5% for the month.
As equity investors, it has become very easy to forget that this kind of market volatility is actually very normal. What was abnormal was a year in which every month the stock market had positive returns and volatility in stock prices actually dropped below that of bond prices for a period of time. Neither of these events had ever occurred before in the markets’ history. It is always easy to be risk averse when stocks are going up, but can be difficult to do when they go down.
As this return of volatility to the markets might make some investors nervous, we thought it would be a great time to review some basic principles of stock investing. One principle is that investing in stocks requires a fairly long time horizon. We typically tell clients that they should look at stock investments in three to five-year spans, as there are too many unpredictable short-term factors that can affect stock prices that have nothing to do with a company’s fundamentals. A stock portfolio should not be looked at to fund near-term cash needs, such as repairs to your house, car or college expenses. Instead, money for these types of expenses should come out of cash equivalents or from short-term bonds in the fixed income portion of the account. It is for this reason that a portfolio’s asset allocation is so crucial, especially for individuals relying on their portfolio for everyday living expenses.
The next principle can make adhering to the first principle very difficult. To be a successful investor, you need to be able to remain calm when everyone around you is freaking out. This can be very difficult in our current age of “instant news.” Warren Buffett has a great saying that he invests by: “Be greedy when others are fearful and fearful when others are greedy.” History has shown that investing fortunes have been made by purchasing great businesses and holding onto them for the long haul, and not by trying to time when to be in or out of the market. A great example of this was in 2008, when at the height of the financial crisis, Warren made a $5 billion investment in Goldman Sachs, when most investors were selling financial companies. As a result, Warren enjoyed $500 million in annual preferred share dividends, as well as the right to purchase Goldman shares below market value.
Another key investing principle is to have a diversified portfolio and to avoid single stock and single economic sector over-concentrations. Having too large a concentration in any one stock can expose an investor to unnecessary risk. Even perennial outperformers can fall on hard times for a multitude of reasons. Names such as Citigroup, Bank of America and AIG outperformed the index for a number of years before the financial crisis. However, in 2008 , these names experienced a significant decline in value, and ten years later have not come close to their pre-crash highs. Similarly, investors should limit their exposure to any one sector. From 2000-2002, the NASDAQ lost about 80% of its value, versus only 30% for the Dow Jones Industrial Average. Those investors with too heavy a weighting in technology stocks during this time period experienced much steeper losses than those investors with a diversified portfolio. More recently, from 2014-2015, the Energy Sector of the S&P 500 experienced losses of almost 30% at a time when a majority of sectors were experiencing gains. Diversifying a portfolio, and having exposure to many broad economic sectors, can significantly reduce investing risk.
Looking at the remainder of 2018, we expect this market volatility to continue. We are not saying that the market is going to be down on the year, as there are still a lot of factors that should affect the market in a positive manner. However, uncertainty about Fed actions, and the White House, are likely to persist, and history tells us that the markets hate uncertainty. The important thing to remember during these times of uncertainty is not to panic. And if there are any big expenses that you are planning for the next two to three years, let us know so that we can make sure those funds are set aside. You do not want to be in a position where you might have to sell stocks at an inopportune time. Finally, if you have concerns that your investment objective might not reflect your needs, please contact either your relationship manager or your investment manager to discuss it.