Volatility: An essential component to higher returns

A monthly business advice column by a financial adviser.

By Robert Toomey

Special to the Reporter

Over the past couple of weeks, global stock markets have experienced significantly elevated volatility due primarily to investor concern over COVID-19 (coronavirus).

Market volatility rises when the outlook for corporate profits or the economy becomes threatened or unclear. The reason for this is the stock market works as a discount mechanism, meaning it will try to look into the future and “discount” to a present value (i.e., current stock prices) expected future corporate profits and cash flows. The outbreak of COVID-19, which has negative implications for growth, has resulted in elevated concern over the outlook for corporate profits, hence rising market volatility.

To put COVID-19 in perspective, we have been here before: since 1980, there have been 12 global viral outbreak episodes. None of these 12 episodes were associated with or the cause of a material economic downturn. Might COVID-19 be different? Possibly because it is hitting closer to home than SARS, MERS or Ebola, but in each of these 12 outbreaks, the economy has always gone on to recover and the stock market has resumed its upward trajectory (the average gain in the stock market measured by the S&P500 in the 12-months following the outbreak of these previous 12 episodes is 13.6%).

Since 1980 there have been 13 “corrections” (declines of 10-20%) and eight “bear markets” (declines of over 20%). The point? Volatility is normal and recurring.

But there is an interesting fact about volatility: It is essential for generating high returns.

History has shown that there is a positive correlation between risk and return. Higher risk assets, namely stocks, have historically delivered over twice the return on bonds (about 10% average annual return for stocks vs. about 4.5% for bonds). However, in order to realize the higher returns generated by stocks, one must be willing to live with and accept a higher level of portfolio volatility. For example, if one wants no volatility in their investment portfolio, they can purchase bank CDs earning 1-2%, or park funds in a money market account earning maybe 1%. No volatility, but very little in the way of return.

The good news is one can capture higher returns with lower risk through portfolio diversification. This involves holding more than one or even several asset classes in a portfolio, such as stocks, bonds, REITs, commodities, alts, etc.

By diversifying by asset class, one can (and should) remain invested during inevitable periods of elevated market volatility, live with less stress, and avoid the temptation to time the market, which is the chief reason why so many investors fail to meet the market averages.

Robert Toomey, CFA/CFP, is vice president of research at S.R. Schill and Associates on Mercer Island.


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