May 2019 Monthly Insight – Is Market Volatility Your Friend?

Posted By T. Lee Sherbakoff, CPA/PFS, CFP® on May 1, 2019


“The only discipline that lasts is self-discipline.”

Bum Phillips–American football coach at the high school, college, and professional levels

Since 1994, DALBAR’s Quantitative Analysis of Investor Behavior (QAIB) has measured the effects of investors’ decisions to buy, sell, and switch into and out of mutual funds over short- and long-term time periods. The 25th Annual QAIB was recently released and the results show the average investor earns less, and sometimes much less, than the actual mutual fund performance they invested in. In short, investors are either moving money into funds after the funds run up in value or are selling and getting out too late after the fund has hit lows. When investors panic and sell out of the market or act out on their fear or greed, they shoot themselves in the foot. As your financial adviser, we seek to educate you about and manage the behaviors that cause you to act imprudently.

The DALBAR report found the average investor did, in fact, take some money off the table last year, but was still in a poor position for the second half of the year. Last year the average investor under-performed in both good and bad times. For example, in August, which was a good month, the market was up 3.26%, but the average equity investor was up only 1.80%. And, in October, a down month, the S&P 500 was down 6.84% but average investors were down 7.97%. For the whole year, the average investor lagged behind the market by over 5%. “Judging by the cash flows we saw, investors sensed danger in the markets and decreased their exposure but not nearly enough to prevent serious losses. Unfortunately, the problem was compounded by being out of the market during the recovery months,” said Cory Clark, Chief Marketing Officer at DALBAR, Inc.

So, what are some ways to guard against the cognitive biases that are preventing us from embracing volatility and realizing that through volatility we can reach our long-term financial goals?
There are three principles of wealth and portfolio management we use at The Nalls Sherbakoff Group to position our clients to have a reasonable expectation of reaching their long-term goals.

  • First is understanding no one can consistently time the market. No one can perfectly, or even almost perfectly time the market.
  • Second, through the financial planning process, we have taken a bottom up approach to select and implement a risk-appropriate portfolio for you.
  • And, third, the annual rebalancing process resets your portfolio back to the risk-appropriate allocation and lets market volatility become the investor’s friend.

We believe in a passive, evidenced-based approach to investing using index-based mutual funds and Exchanged Traded Funds (ETFs). Many active managers who try to time the market may outperform the market in the short-term, but may significantly underperform over longer periods. Even though we recognize some active managers will outperform the market in the short-term, there is no way to predict which manager will outperform in the future. There is no process, algorithm, prophecy, or amount of research that can identify which manager will be next year’s leader.
Further, selling out of your current funds to buy last year’s winners doesn’t work either. Active fund managers who do outperform have no demonstrated persistence in consistently outperforming. Thus, with no methodology to identify in advance which active managers will outperform plus no demonstrated persistence from managers who have recently outperformed, investing in low cost, passive, index-based funds is a more efficient way to invest. Why? Because in the long run, active managers just turn out to be average anyway.

Second, through the financial planning process, we together have discussed your financial goals and objectives, reflected on your need and emotional capacity to accept risk, and discussed and reached a joint conclusion on the proper long-term allocation deployed in your investment portfolio. This process led to a custom allocation to support you future needs. Further, your portfolio allocation strategy is so allocated as to manage the volatility and risk in the market at a level that supports your stated goals and risk tolerance. In fact, your allocation actually contemplates volatility and encourages it.

As we mentioned above, you should choose a portfolio you can live with despite market fluctuations. However, with those fluctuations is the opportunity to rebalance the portfolio, the third principle. This process of rebalancing—which sells after the market has gone up and buys after the market has gone down—is sometimes referred to as “volatility capture” and leads to excess growth and can provide incremental returns: the purported “free lunch.” The rebalanced portfolio will grow faster than the average growth of its individual constituents. If handled skillfully, market volatility again can be the investor’s friend.

The frightened investor who decided to get out of the market in March 2009 or even last December 24 when we hit bear mark territory, down 20%, locked in losses for good. The primary problem with investors, as shown in the DALBAR report, is they buy after the market has gone up and believe it will rise further and they sell after the market has fallen and believe it will fall more. One of the primary tasks we do for you is to make sure you understand the volatility of your portfolio and are willing to stick with it for the long run.