Investing in a Volatile Market

Photo by Geralt on Pixbay

It is December 16th and year to date the S&P 500 is down 3.35% for the year. Unless something unexpected happens in the next week (like a resolution to the trade war) the stock market will have its first down year since 2008.

A 3.5% loss in 2018 is certainly not as scary as the 37% loss in 2018. However, for many investors particularly young investors this might be their first taste of volatility.

What exactly do I mean by “volatility?” Let me explain it using two graphs.

First, here are the returns of the S&P 500 Index from the past 10 years.

Apart from a few minor (and brief) dips the stock market had been steadily climbing for a decade. Anyone investor 35 probably began investing during sometime during this period. Notice this graph ends at the end of 2017. To appreciate how calm the stock market has been the past decade, let's look at what 2018 brought us.

This is what volatility looks like. Sudden and massive drops followed by spikes in prices. Looking at this chart you might be surprised that the market is within 3.35% of where it was a year ago.

When you think about it 3.35% is a relatively small change. If the market only has a positive return of 3.35% in 2017, people would have been disappointed. But when the ride to 3.35% is this bumpy, people begin to get nervous.

They might even be nervous enough that they consider changing up their entire investment strategy. That brings us to our reader question of the week.

Reader Question of the Week from Seth Farley

When reading an article I wrote about low-cost, passive Index Funds Seth left a question in the comments asking the following:

Thank you for your articles on investments, Ben! You make it easy for newbies like me to understand these concepts. Please keep writing more of them.
Your case for choosing low-cost index funds over traditional mutual funds makes sense, especially in a market with lower volatility. However, what do you suggest investing in during times of high market volatility?
For example, I’ve been seeing news reports discussing significant recent declines in the price of shares for Facebook and Apple, stocks which (in my understanding) often constitute a large percentage of technology-focused index funds.
Would an actively-managed, tech-oriented mutual fund that deliberately de-emphasizes the performance of these companies be a better investment, the higher MER cost notwithstanding?
Given the market’s unpredictability of late, I would greatly appreciate seeing an article from you on how to best diversify a portfolio in times of intense market uncertainty.

First, thanks for the comment and the kind words Seth.

If you have read a lot of my articles you’ve heard me talk a lot about index funds. There are two reasons why I personally invest in index funds rather than actively managed, “traditional” mutual funds

  1. They have lower management fees
  2. Very few active investors can beat the market in the long term

For a more detailed explanation of low-cost index funds check out this story.

Seth's question is essentially this “does passive investing still make sense during times of high volatility?

I would be more inclined to take a route of passive investing during times of high volatility. The only reason someone might switch from passive to active investing in a highly volatile market is to avoid losses.

Let me be clear. If you are investing in the stock market, you are going to have periods (or years) where you experience losses. That is a fact of life that you must accept.

The question remains do actively managed mutual funds outperform stock indexes during a bear market?

To answer this I refer you to a fantastic blog post from Michael Arone. Michael looked at the data comparing the performance of actively managed funds to stock market indexes during a bear market.

He found that most actively managed funds underperformed the market during a bear market. So not only are you paying higher fees, but chances are you are getting weaker returns. I won’t tell you what to do with your money, but for me, that is a hard pass.

Why might this be? Well if you have read our featured story on Making of a Millionaire, you would know that the human brain sets us up to be bad at making investment decisions. We get greedy, we get fearful, we get stuck inside a bubble where we don’t expose our selves to new information.

The more investing decisions we must make, the more chance we give our brains to screw it up. During a volatile market like we see today, there are a lot of potential questions for the active investor to make.

As Seth points out, technology stocks which a year ago seemed unstoppable are now loss leaders in 2018. The active investor might think “I better dump some of my technology stocks”.

Is that the right decisions? I have no idea, and that’s the point. Technology stocks could continue to slide in 2019 or the could bounce back and become stronger than ever.

If you sold Facebook stock while it is down 36% for the year, you would feel stupid locking in a loss if it increases by 46% in 2019.

On the flip side, if you decided to double down and invest more in Facebook because you believe it will bounce back in 2019, you will feel pull your hair out if Facebook continues to slide another 36% next year.

Ultimately, we all must do our own research and find the investing style that works best for us. I have two degrees in Economics, and if I have learned anything during my studies, its that I know nothing when it comes to predicting the market.

That is why I stick to passive investing.

If you have a question you want to be addressed in a future post leave it in the comments below.

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.