The one thing we know we can always predict with regard to the stock market is there will always be periods of heightened market volatility.
Market volatility is a curious thing. It is primarily driven by uncertainty, an uncertain or murky outlook for a variety of factors such as the economy, interest rates, inflation, and corporate profits, to name a few. While volatility creates anxiety for investors it is also, ironically, a key component to achieving higher long-term returns.
History, as reflected in the Capital Asset Pricing Model (CAPM), has shown that investors willing to stomach a higher level of portfolio volatility should earn a higher rate of return on their investments.
Right now, investors are sizing up the investment outlook for the remainder of 2020. It has been an interesting year to say the least. Chief concerns for investors now are 1) the potential for a rise in COVID infection in the flu season and 2) the upcoming presidential election.
The dramatic recovery in the stock market from its March 2020 lows has surprised many people and has been driven by rising investor confidence in a recovery from COVID and an improved outlook for corporate earnings in 2021 and 2022. A material spike in COVID cases could slow the pace of the recovery which, in turn, could result in lower expectations for the economy in 2021.
Another growing concern for investors is the risk of a contested presidential election that could potentially drag out for several months.
While I agree this is a concern, there are several factors that provide an offset to this risk. This includes a highly accommodating Federal Reserve policy and a continuation of improvement in the economy driven in part by CARES Act and government stimulus. A contested election will ultimately be resolved and if not by January 20, 2021, we have provisions in our Constitution to assure a smooth transition of power.
Our clients often ask what to do in the face of these risks. Our response is straightforward: 1) these concerns will most likely not have a long term impact on portfolio returns; 2) have a financial plan; 3) stay disciplined to your financial plan. Despite both of the risks discussed above, we expect the annual rate of return on U.S. stocks will remain close to the historic 10% level on a long-term basis due to the resilience of our economy.
With respect to COVID, we are encouraged by the advancements made in both treatments and a vaccine and expect continued gradual improvement in the outlook for treating and overcoming COVID which should become more visible in 2021. For clients concerned about volatility, we would always advocate sticking to the discipline of the investment allocation derived from a sound financial planning process and not attempting to time the market.
History and research have shown that avoiding market timing and sticking to a sensible asset allocation are the best ways to weather bouts of market volatility and generate superior risk-adjusted returns.
Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.