Maintaining Discipline in the Face of Market Volatility

Maintaining Discipline in the Face of Market Volatility

It’s easy to get swept up in the market’s volatility of late. 2016 saw one of the worst market openings ever. Financial media has been screaming “Sell everything.”

It’s important to remember how well-functioning capital markets work. They reflect all the expectations of the market’s participants, including risk aversion and expectations of future profits.

What the Market Fluctuation Means for You

Markets adapt to changing expectations and new information instantly. The markets are so fast that they’ve factored in the information before you even hear about it. It’s impossible to predict the market.

This is actually good news for you, though. Think about the alternative. If prices didn’t adjust, we’d worry the market wasn’t functioning properly. Plus, if there was no risk, there’d be no return.

So let’s look at January 2016.

What January 2016 Means for the Rest of the Year

The year got off to a bleak start. The opening days gave us the worst start of a year for the Dow Jones Industrial Average ever. The first two weeks of January were the worst first two weeks of a year for the S&P 500 in history. The index returned −7.93% from January 4 through 15.

During the month, the S&P 500 Index had a return of −4.96%, the ninth lowest return for the index since 1926.

This raises the question: Do January’s returns mean anything for returns the rest of the year?

The answer is no.

The Truth About January’s Market Returns

The -4.96% drop in January 2016 brought the market down 10.43% from its high on Nov. 3, 2015. This marked the second decline of at least 10% since August 2015.

You should take two truths away from this.

A negative January doesn’t mean poor market returns for the rest of the year. Exhibit 1 shows negative January returns from 1926 to 2015 and compared them to the returns of February through December. A negative January was followed by a positive return 59% of the time, with an average return of 7%.

Maintaining Discipline in the Face of Market Volatility

If we look at the five lowest January returns from 2015 and earlier, the average was 13.8%. Likewise, none of those years finished in the lowest 20 years of annual returns for the S&P 500 Index.

It’s also worth thinking about what happens after a steep decline in the market. As we’ve discussed in the past, markets actually do pretty well after a sharp drop. This just emphasizes the need to stay disciplined, no matter what the market does.

Take a look at Exhibit 2.

The markets aren’t as volatile right now as you might think. The return of the S&P 500 between 1926 and 2015 was positive on average. The index had a compound return of 10.02% and a standard deviation of 18.85%. Exhibit 2 compares those long-term numbers with more recent times.

Maintaining Discipline in the Face of Market Volatility

Between January 2010 and December 2015, the return was 12.98%, with a standard deviation of 13.09%. In other words, over the past six years, we’ve had higher than normal returns with lower than normal standard deviation.

Don’t Make This Market Volatility Mistake

We shouldn’t assume future returns will be negative just because the market has dropped. The return for any period may be positive or negative, but markets have this persistent tendency to go up over time.

The best thing you can do is remain disciplined with your investments. Understanding how financial markets work can help you in that regard. Take a look at our ebook “A Minimalist’s Guide to Understanding Financial Markets” to see how everything fits together.

 

 

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