This is the continuation of a 10 part blog series entitled, “10 MACRO HEADWINDS IN THE FACE OF INVESTORS.”
It’s an appropriate day to talk about volatility within the equity markets. Yesterday the NASDAQ hit a daily high of 2,688.86 about mid-afternoon. Today NASDAQ hit an intra-day low of 2,576.22 (and the day isn’t over yet). That’s a 4.37% swing within 24 hours of trading. And we wonder why investors don’t feel confident in equity markets?
Investors do not like volatility. It’s too hard on us emotionally to watch our hard earned savings swing up and down without rhyme or reason. It gets worse as we get older and accumulate more wealth. But this makes sense if we analyze why. Let’s go through an example.
Let’s say you are a 25 year old investor who is just out of graduate school and just starting out your long term savings and investing plan for retirement. And let’s say you are a great saver with a strong income because you are a Mr. Smarty Pants. You can save $1,000 a month (impressive for a 25 year old) and you have now been saving for 10 months.
After 10 months of hard saving you have accumulated $10,000 and right after hitting your 5 figure milestone, the stock market experiences a 20% pullback and you were invested in stocks. Now your $10,000 portfolio has dropped down to $8,000. That’s a set-back for sure but since you could save $1,000 a month, after three more months of savings, your portfolio is at all new highs of $11,000 even after experiencing a large 20% decline in performance. You could literally out-save poor investing performance.
Now let’s compare that to an older and wealthier investor. Let’s say that it is a married couple that is 60 years old, quickly approaching their desired retirement age of 65. They have accumulated $1.5 million dollars and are currently saving a very impressive $50,000/year. If their $1.5 million portfolio goes down the same 20% as the previous young buck investor experienced, that would equate to a $300,000 decline. I remind you that they are able to save $50,000/year (over 4 times the amount of savings as the 25 year old investor). Yet, where the young investor was able to save his way to all new highs after just a few months, the older couple would require over 6 years of savings at $50,000/year to close the gap on a 20% decline in their portfolio. That is a painful acknowledgement!
And so we can now understand that volatility impacts investors in different ways depending on age, wealth, emotional tolerance, and ability to save.
Our markets started going crazy again with volatility back at the end of July of 2011 as the European debt mess started making headlines again. I did a little original research since then. I took the high value of the S&P 500 each day and subtracted the low value of the S&P 500. I took that daily difference between the daily high and low and I divided the value by the previous day’s closing price. What I found was that over the past 4 months, the daily difference was 2.6% on average. That daily difference is higher than the average dividend yield of S&P 500 companies (which is about 2.3%). An investor who owns the average S&P 500 dividend stock could see the daily price swing higher than an entire years’ worth of dividends.
Why would we think an average investor would feel comfortable investing their hard earned savings in a market that is experiencing so much volatility? We can conclude that “in the long run” stocks will outperform bonds (especially since bond yields are near all-time lows), but the investor has to have the ability to weather the emotional storm along with the underlying systematic risk of the Europe debt mess.
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