Gains of nearly 30% on a broad index like the S&P 500 — after four years of above average growth — has given investors many reasons to rejoice. And it’s not just the absolute return that investors have relished; it’s the smooth fashion in which we’ve reached that number.
In 2013 we saw only 17 days where the index fell by over 1%, and no days when it fell by over 2.5%. Looking at the last 20 years we would expect to see 35 days where the index fell by over 1% in a given year, meaning 2013 had only half the number of significantly down days that we would expect.
And the volatility has disappeared not only on a daily basis, but on a cumulative basis as well. The chart below shows the annual drawdowns of the S&P 500 since 1972. The last two years have had very small drawdowns of around 6%; this is really nothing worse than a bad week or two on the index. With volatility so low for a few years, it’s easy to extrapolate this tranquility into the future, assuming the market will continue to be a smooth ride.

Yet we know this won’t continue forever. When you look at the other years in the chart, you can see that the average drawdown we should expect within any given calendar year is actually over 10%. More volatile areas like small cap securities should expect drawdowns of 15% annually.
When we think about expected returns on indexes, it’s easy to gloss over the fact that there are not only down years like 2008, but historically there are significant periods within each year when markets fall meaningfully. Take 2010 for example. While the market finished up over 15% for the year, during the year the index actually experienced a fall of 13%. Fears ran rampant at the time that a stagnant economy would pull the US back into a double dip recession. Yet those investors who were able to stay the course ended the year up double digits.
We know there will be ups and downs along the way, sometimes very significantly. For those investors with the patience and resolution to stay invested there has been significant compensation for riding out the storms, to the tune of $65 for every $1 invested in 1972. In order to help reduce the volatility we expect on a yearly basis, and the chance an investor is not able to ride out the storm, a portfolio should include an allocation to short term, high quality fixed income. By finding the right mix between the riskier stocks and the less volatile bonds, a portfolio can be tailored to take only the risk needed to achieve an investor’s goals.
Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.
As an advisor are your clients prepared for the rocky patches we know we’ll hit along the way? Will they be more likely to buy or sell the next time markets drop? We don’t know what 2014 will have in store for us, but as we enjoy last year’s gains, don’t get complacent and expect another year virtually devoid of volatility. Plan for volatility to make a comeback at some point, but don’t be scared off by it.
Source: Morningstar Direct 2013. Market segment (Index representation) as follows: U.S. Large Cap (S&P 500 Index. Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.
Fixed income securities are subject to interest rate risk because the prices of fixed income securities tend to move in the opposite direction of interest rates. In general, fixed income securities with longer maturities are more sensitive to these price changes and may experience greater fluctuation in returns.
All investments involve risk, including loss of principal. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting.