volatility and the long-term investor · volatility and the long-term investor ... supposedly...

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Volatility and the Long-Term Investor

understanding the reality behind some common misconceptions

online report consulting group

Market volatility has long been a source of anxiety for equity inves-tors. Over the past several years in particular, signifi cant fl uc-tuations in market value caused many investors to rethink—and sometimes entirely restructure—their investment portfolios, substantially reducing (or even eliminating) their equity alloca-tions. While past performance is not indicative of future results, a brief examination of long-term trends in investment performance may help put short-term market volatility in perspective. Under-standing the truth behind some common misconceptions about volatility can be an important step in the prudent management of your overall portfolio.

Stocks play a major role in most portfolios, but sudden market

movements can cause doubts about the wisdom of a long-term commit-ment to equity investing. It is impor-tant, however, to put market volatility in the proper perspective. Sudden declines are hardly uncommon in the stock market, and in fact can be part of a normal market cycle. The risk of short-term loss is one that equity investors simply must be prepared to accept. While diversifi cation and prudent portfolio management may reduce this risk, it cannot be elimi-nated entirely.

As we know from the past several years, a serious bout of market vola-tility can be alarming, particularly when you’re not expecting it. Amid such uncertainty, it is all the more important to keep your eyes on the market’s true prize: the potential for better-than-average long-term per-formance. Since the mid-1920s, long-term investors in US stocks typically have been rewarded for the risks they have taken—despite the occasional bear markets.

There’s no question that staying invested and doing nothing can be hard when the value of your equity portfolio has fallen by 10% or more. This may seem too risky compared to supposedly “safe” investments such as long-term government bonds or money market funds. But success-ful investors avoid the temptation to adjust their portfolios in response to every short-term dip in the market.

Investors should also understand that many widely accepted “facts” about market volatility are actually dead wrong. Here’s a look at a few of these myths and the realities behind them.

myth: market volatility is getting worse all the time. owning stocks today is a lot more risky than it was 20 or 30 years ago.

reality: It’s true that the past few years saw an upswing in vola-tility, as measured by daily price movements. There were 134 days in 2008—at the peak of the fi nancial cri-sis— when the S&P 500 Index moved up or down by 1% or more. That’s up

consulting group | morgan stanley smith barney 2

from 29 days in 2006—just two years earlier. However, this cyclicality is part of a long-term pattern. As the chart on this page shows, daily vola-tility has risen and fallen repeatedly in cycles over the past 30 years.

In any case, sharp daily moves, while unsettling, don’t tell the whole

story. Investment analysts typically measure volatility by looking at stan-dard deviation: the degree to which market returns in any given quarter diverge from their long-term trend. By this measure, market risk has not increased appreciably over the past 40 years. During the ten years

ending in 2010, which included both the internet bubble and the Great Recession, the standard deviation of returns for large US stocks was 18.7%—only slightly higher than the 17.3% seen in the decade ending in 1990 and 17.4% in the decade ending in 1980.1

myth: after the kinds of gains investors saw in the late 1990s or mid-2000s, the law of averages guarantees the next decade will be a bad time to own stocks.

reality: It’s true that market re-turns in the late 1990s and mid-2000s were high by historical standards, but there is no “law” that requires returns to be below average in the future because they’ve been higher than average in the past.

Using the S&P 500 Index as a proxy, investors would have earned an annualized return of about 9.9% on large-capitalization stocks from 1926 through 2010—and this despite the market turmoil of the past four years.2 Whether returns are better or worse in coming years will depend on economic factors such as infl ation, interest rates, earnings and global events—not the laws of probability.

myth: when the market starts to rise, smart investors can always jump back in and ride the next leg up. mean-while, the safest thing to do is to stay in cash.

reality: Timing the market is something that even many profes-sional investors cannot do consis-tently. And the costs of being out of the market for even a short time can be enormous. As the chart on the left illustrates, from 1980 to 2010—a period containing more than 7,500 trading days—an investor who missed the 50 biggest “up” days would also have missed approximately 98% of the increase in stock prices during that period, converting an 8.4% annu-alized return into an annualized gain of only 0.2%.

online report / volatility and the long-term investor

Daily Moves in the S&P 500 Index of More Than 1%(1980-2010)

Source: Consulting Group, PolarisInvestors cannot invest directly in an index. Past performance is no guarantee of future results.

0

25

50

75

100

125

150

1980 1986 1992 1998 2004 2010

30-Year Average:

65

Annualized Performance of the S&P 500 Index(1980-2010 Net of Dividends)

Source: Consulting Group, PolarisInvestors cannot invest directly in an index. The performance of the index refl ects no deductions for fees, expenses or taxes which would lower the performance of managed assets. Past performance is no guarantee of future results.

0.2%1.4%

2.7%

4.1%

5.8%

8.4%

0%

5%

10%

Full Period Less the 10Biggest Up

Days

Less the 20Biggest Up

Days


Days


Days


Days


myth: while stocks have paid higher returns than bonds or treasury bills over the long run, the difference hasn’t been all that great.

reality: Over the past 85 years, returns on stocks have beaten cash and bonds not by a narrow margin, but by huge margins. For an example, an investor who put $1 in large capi-talization US stocks at the beginning of 1926 could have seen that dollar grow to almost $3,000 by the end of 2010. By comparison, that same dol-lar invested in long-term government debt would have grown to just $92, while $1 invested in Treasury bills would have been worth only $20.

myth: buying near the top of a bull market is an easy way to lose money over the long run.

reality: Historically, investors who put money in the stock market

near a short-term peak have done well over the long run—particularly when compared to Treasury bills and other supposedly “safe” invest-ments. An investor who put $10,000 in large capitalization US stocks at the month-end following the tops of the last eight bull markets could have had a portfolio worth more than $1.7 million by the end of 2010. By com-parison, someone who invested the same amounts in Treasury bills at the same times would have had slightly less than $394,000.3

myth: even if long-term returns are higher for stocks, they still aren’t high enough to justify the risk of short-term losses.

reality: It’s true that stocks have historically been more volatile than bonds or Treasury bills but stocks have also provided greater rewards

than bonds and Treasury bills over the long term.. Total returns on the S&P 500 have been positive in 61 of the past 85 years—or approximately 72% of the time. There have only been 11 years in which the market lost more than 10%, and only six years when it lost more than 20%.

On the other hand, returns have been greater than 10% in 49 of the past 85 years, and greater than 20% in 32 of those years.

myth: stocks may have beaten bonds and treasury bills over the long run, but that’s only because the stock market has had a few great years. there have been many periods of time when stocks have underperformed bonds and treasury bills.

reality: In 38 of the past 65 years—or about 58% of the time—the


Cumulative Return of $1(1926-2010)

Source: Consulting Group, Polaris, MorningstarInvestors cannot invest directly in an index. The performance of the index refl ects no deductions for fees, expenses or taxes which would lower the performance of managed assets. Please see the disclosures at the end of this document for a list of indexes associated with the above asset classes. Past performance is no guarantee of future results.

$0

$1

$10

$100

$1,000

$10,000

$100,000

1926 1932 1938 1944 1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 2009

Small Cap Large Cap Long-Term Gov’t Bonds T-Bills Inflation

$17,016

$2,982

$92$20$12



S&P 500 has produced higher returns than Treasury bills or long-term government debt. Over longer peri-ods, the results have been even more lop-sided: from 1945 through 2010, stocks outperformed Treasury bills and long-term government debt in 42 of 61 rolling fi ve-year periods—almost 69% of the time. Over rolling 10-year periods, stocks outperformed more than 80% of the time, and stocks have outperformed Treasury bills and long-term government debt in all but two rolling 20-year periods since 1945.

conclusionOf course, we all know that past

performance is no guarantee of fu-ture results. There have been lengthy periods—such as the late 1970s—when US stocks delivered relatively poor risk-adjusted performance. Investors may be able to improve long-term results, and reduce volatil-ity, by including fi xed income, foreign equities and other asset classes in a diversifi ed portfolio.

Still, the moral of the story should be clear: investors who act in haste—fl eeing the stock market when the going gets rough—are likely to repent at leisure. The real risk investors face isn’t just the possibility of further market volatility, but also the damage that could result from making sudden or rash changes in their long-term investment strategies—changes they may regret later.

1 Source: Consulting Group, Polaris.2 Source: Consulting Group, Polaris.3 Source: Consulting Group, Polaris. Bull-market peaks were calculated for the following months: Feb. 1966, Dec. 1968, Jan. 1973, Dec. 1980, Oct. 1987, June 1990, Jan. 2000 and Nov. 2007.

Distribution of Returns for the S&P 500 Index(1926-2010)

Source: Consulting Group, PolarisInvestors cannot invest directly in an index. The performance of the index refl ects no deductions for fees, expenses or taxes which would lower the performance of managed assets. Past performance is no guarantee of future results.

-40%-50%

-30%-40%

-20%-30%

-10%-20%

0%-10%

0% +10%

+10% +20%

+20% +30%

+30% +40%

+40% +50%

+50% +60%

19312008 1937 1930

1974192819351958

1947194819561960197019781984198719921994

1927193619381945195019551975198019851989199119951997

19261944194919521959196419651968197119721979198619881993

19331954

1982

1942194319511961196319671976

1983199619981999

1929193219341939194019461953196219691977198119902000

1929193219341939194019461953196219691977198119902000

19411957196619732001

19411957196619732001

2002

2003

2004

2005

Up Years: 61 (72%)

Down Years: 24 (28%)

2006

2007

2009

2010

Top-Performing Asset Classes(1945-2010)

Source: Consulting Group, Polaris, Morningstar, Dec. 31, 2945 - Dec. 31, 2010Investors cannot invest directly in an index. Please see the disclosures at the end of this document for a list of indexes associated with the above asset classes. Past performance is no guarantee of future results.

444542

38

1613

4 2

116 7

00

10

20

30

40

50

Annual Rolling 5-Year Rolling 10-Year Rolling 20-Year

US Large Cap Stocks Long-Term Gov’t Bonds T-Bills

Num

ber o

f Per

iods


The large capitalization stock performance cited in this report is for the S&P 500 Index. The S&P 500 is widely regarded as the best single gauge of the U.S. equities market, this world-renowned index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Although the S&P 500 focuses on the large-cap segment of the market, with over 80% coverage of U.S. equities, it is also an ideal proxy for the total market.

The Treasury bill performance cited in this report is for 90-day Treasury Bills. Equal dollar amounts of three-month Treasury bills are purchased at the beginning of each of three consecutive months. As each bill matures, all proceeds are rolled over or reinvested in a new three-month bill. The income used to calculate the monthly return is derived by subtracting the original amount invested from the maturity value. The yield curve average is the basis for calculating the return on the index. The index is rebalanced monthly by market capitalization.

Infl ation is measured in this report using the Consumer Price Index (CPI). The Consumer Price Index for all urban consumers is a measure of change in price of goods and services purchased by all urban consumers. Approximate-ly 400 items make up the basket of goods and services measured. Returns prior to 1947 are not seasonally adjusted. Returns from 1947 forward are seasonally adjusted. By using seasonally adjusted data, economic analysts and the media fi nd it easier to see the underlying trend in short-term price change. It is often diffi cult to tell from raw (unadjusted) statistics whether developments between and 2 months refl ect changing economic conditions or only normal seasonal patterns. Therefore, many economic series, includ-ing the CPI, are seasonally adjusted to remove the effect of seasonal infl u-ences. Seasonal infl uences are those that occur at the same time and in about the same magnitude every year. They include price movements result-ing from changing climatic conditions, production cycles, model changeovers and holidays.

The Long-Term Government Bond performance used is this report sourc-es the Ibbotson Long Term Government Bonds Index. The total returns from 1977-present are constructed with data from The Wall Street Journal. The data from 1926-1976 are obtained from the Government Bond File at the Center for Research in Security Prices (CRSP) at the University of Chicago Graduate School of Business. To the greatest extent possible, a one bond portfolio with a term of approximately 20 years and a reasonably current coupon-whose returns did not refl ect potential tax benefi ts, impaired nego-tiability, or special redemption or call privileges-was used each year. Where “fl ower” bonds (tenderable to the Treasury at par in payment of estate taxes) had to be used, the term of the bond was assumed to be a simple average of the maturity and the fi rst call dates minus the current date. The bond was “held” for the calendar year and returns were computed.

The Small Cap performance used in this report sources the Ibbotson Small Company Stocks Index. The Small Company Stock return series is the total return achieved by the Dimensional Fund Advisors (DFA) Small Com-

pany 9/10 (for ninth and tenth deciles) Fund. The Fund invests in a broadly diversifi ed cross section of small companies. Portfolios are fully invested: Dimensional keeps cash levels below 5%, and generally under 2%. Portfolio turnover averages 20-25% annually.

Ibbotson index performance is calculated by Consulting Group and Mor-gan Stanley Smith Barney using data provided by Morningstar. ©2011 Morn-ingstar, Inc. All rights reserved. Used with permission. This information contained herein: (1) is proprietary to Morningstar and/or its content pro-viders; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this infor-mation.

The illustrations in this report are hypothetical and do not refl ect the results of any actual investment. The data do not refl ect the material differ-ences between stocks, bonds, bills and infl ation, such as fees (including sales and management fees), expenses or tax consequences. Common stocks gen-erally provide an opportunity for more capital appreciation than fi xed income investments but are also subject to greater market fl uctuations. Corporate bonds, US Treasury bills and US government bonds fl uctuate in value but, if held to maturity, offer a fi xed rate of return and a fi xed principal value. Government securities are guaranteed as to the timely payment of interest and provide a guaranteed return of principal. The principal value and inter-est on treasury securities are guaranteed by the US government if held to maturity.

Past performance is not a guarantee of future results. Statements of fact and data in this report have been obtained from, and

are based upon, sources that the Firm believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the Firm’s judg-ment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

Diversifi cation does not assure a profi t or protect against loss.Investing in the markets entails the risk of market volatility. The value of

all types of investments may increase or decrease over varying time periods. Small capitalization companies may lack the fi nancial resources, product diversifi cation and competitive strengths of larger companies. In addition, the securities of small capitalization companies may not trade as readily as, and be subject to higher volatility than, those of larger, more established companies.

With respect to fi xed income securities, please note that, in general, as prevailing interest rates rise, fi xed income securities prices will fall.

© 2011 Morgan Stanley Smith Barney LLC, member SIPC. Consulting Group is a business of Morgan Stanley Smith Barney LLC.

2011-PS-371 2/11


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