Wealth Matters: Diversifying is key to riding out stock market swings

Mark Keating, CFP, AEP, is a certified financial planner and wealth adviser at Willow Creek Wealth Management (www.willowcreekwealth.com or 707-829-1146).

Wealth Matters is a monthly column by the firm’s advisers.

The last 12 months have proved a testing time for many investors. Although the S & 500 Index at the end of April was roughly where it was a year ago, share prices have been on a roller-coaster ride in the intervening period.

The index recorded drops of 11.8% and 16.7% in calendar 2022 and two drops of over 7% year to date. This level of volatility is difficult to stomach, and most investors find it hard to remain calm during substantial market declines.

Therefore, it is important to remind ourselves that experiencing volatility, even large market swings, is part and parcel of investing — that volatility in asset prices is completely normal. Even more crucially, we need to remember that reacting emotionally to volatile markets may be more detrimental to portfolio performance than the drawdown itself.

Equity markets experience significant ups and downs all the time. Chart 1 shows the returns of the Russell 3000 Index over the last 43 years as well as the largest intra-year declines that occurred during a given year. Since 1979, the Russell 3000 Index (a broad market-capitalization-weighted index of public U.S. companies) has experienced intra-year declines of more than 10% in almost 60% of the years observed and declines of more than 15% in more than a third of the years.

During this period, the average intra-year decline was about 14%. Nevertheless, despite these substantial intra-year drops, calendar year returns were positive in 36 out of the 44 time periods examined — or 82% of the years. This data illustrates just how common market declines are and how poorly correlated they are to annual returns. Just because stocks fall sharply sometime during the year does not mean they will end the year with a negative return.

Since equity market swings happen so frequently, some investors may be tempted — or frightened — into trying to time the market. They want to get out “near the top” and buy back in again “near the bottom.” Certainly, the idea of using short-term strategies to avoid near-term pain, all without missing out on long-term gains, is seductive. But research repeatedly demonstrates that timing strategies are not effective.

For a start, predicting equity market ups and downs is next to impossible, even if you think you know what is going to happen. Consider the most recent time period. U.S. equities weathered a pandemic, the Russian invasion of Ukraine, spiking inflation, a sharp rise in interest rates, bank failures, and ongoing recession fears.

Despite all this bad news, equities generated robust positive returns for the three years ending Feb. 28, 2023, with the Russell 3000 Index recording a sizable 11.79% annualized return. If they had been given a crystal ball forecasting these events in February 2020, few investors would have predicted higher equity prices over the next three years. The fact is markets do not react predictably to new information.

Moreover, mistiming your exit and entry into the equity market, even by just a few days, can have a large detrimental impact on your portfolio’s return. Data analysis of the returns of the S & 500 Index over the last 28 years ending Sept. 30, 2022, shows that missing a very small number of “best” trading days (when the market return was greatest) causes a marked reduction in portfolio returns.

For example, a portfolio that missed just 20 “best” days of the 6,993 trading days in the period covered cut returns by 65% compared to a portfolio that stayed fully invested over the entire period.

Clearly, trying to time the market in an attempt to mitigate losses is a perilous activity. A wiser approach is to use diversification. Today, through mutual funds and ETFs, most investors can access broadly diversified investment strategies at very low cost. While some risks — specifically systematic risks such as that of recession — cannot be diversified away, diversification is still an incredibly effective tool for reducing nonsystematic risk.

In particular, by ensuring that all positions and exposures are relatively small as a percentage of the portfolio, diversification can reduce the potential pain of a poorly performing stock or sector. Diversification can also smooth out returns as different parts of a portfolio will be producing positive returns at different times.

When markets react negatively to events, many investors feel like they should be doing something with their portfolios. Often, headlines and pundits stoke these sentiments with predictions of more doom and gloom. Nevertheless, most investors would be far better off resisting the siren call to tinker with their portfolio and instead remember that market volatility is totally normal, that market timing usually destroys more wealth than it protects, and that diversification does a great job reducing risk.

Mark Keating, CFP, AEP, is a certified financial planner and wealth adviser at Willow Creek Wealth Management (www.willowcreekwealth.com or 707-829-1146).

Wealth Matters is a monthly column by the firm’s advisers.

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