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Stock Market Volatility – Time and Diversification

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In 2018, the stock market reminded investors that it doesn’t always go up and that volatility is alive and well. In fact, the S&P 500 index recorded its first losing year since 2008, the height of the financial crisis. So far in 2019 the markets have bounced back a bit.

This chart from JP Morgan Asset Management’s quarterly Guide to the Markets does an excellent job of illustrating the relationship between time, portfolio diversification and the potential volatility of investment returns.Time, diversification and the volatility of returns

Source: JP Morgan Asset Management Guide to the Markets

A brief explanation

The chart illustrates the returns of stocks, bonds and a 50/50 mix of the two over rolling 12-month, 5-year, 10-year and 20-year periods dating back to 1950 and through the end of 2018, a time period that includes the Black Monday crash of 1987, the bursting of the Dot Com bubble and the financial crisis of 2007-09. In each grouping, the green bar represents stocks, the blue bar represents bonds and the grey bar represents a 50/50 mix of the two.

Stocks are represented by the S&P 500 and bonds by Bloomberg Barclays Aggregate since 2010, with a predecessor benchmark used prior to that.

The impact of time

As you go from left to right on the chart, the time periods get longer. As the time period increases, the range of returns becomes narrower. For example, the range of rolling 12-month returns for stocks is +47% to -39%. The range over rolling 20-year periods is +17% to +6%.

This relationship is true in all cases depicted. Time minimizes the impact of investment volatility.

Diversification 

Stocks are more volatile and will almost always have a wider disparity in returns over time than bonds. This is especially true over the short-term as depicted in the chart.

The chart also shows that a 50/50 allocation to stocks and bonds has a narrower range of returns than either asset class by itself. This is in large part due to the fact that stocks and bonds have a low and negative correlation to each other. According to another chart in the JP Morgan presentation, that correlation coefficient for the S&P 500 and the Barclays Aggregate Bond Index is -.18 for the ten years ending in 2018. This means that there is a low and slightly negative correlation in the performance of the two asset classes and that the factors that impact the performance of these two investment types are not that closely related.

What are the implications for investors? 

There is nothing new or profound in this chart, but none the less the data as portrayed is important for investors to remember, especially in times of market volatility.

It’s easy to panic and fall victim to the all of the pronouncements we tend to hear in the financial media any time the market experiences a period of volatility. The reality is that markets do not always go up, some volatility as well as periods of negative returns are normal parts of the market cycle.

Investors should use these periods of volatility to review their holdings and their asset allocation to determine if it fits their risk tolerance and their investing timeframe. They should rebalance their portfolios and adjust their allocation as appropriate. The correct allocation will likely be different for someone who is 35 with a long time until retirement versus someone in their 50s and within ten years or less of retirement. While the 50/50 allocation portrayed is for illustration purposes only, it is important to consider including some holdings that are not highly correlated to other holdings in your portfolio.

While there is no way to predict the future, we are in the midst of the longest running bull market for stocks in history. Add to this the uncertainty in Washington in terms of economic policy and the ingredients for continued market volatility are certainly in place.

Approaching retirement and want another opinion on where you stand? Not sure if your investments are right for your situation? Concerned about stock market volatility? Check out my Financial Review/Second Opinion for Individuals service for detailed guidance and advice about your situation.

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