Invest Despite Volatility

Bipolar Up and Down Arrow Volatility on Warning Sign Many facets of investing are counterintuitive. Investment strategies that feel right seldom are. A classic example of this is how to deal with market volatility. During a recent investment seminar I gave to Dropbox employees, I asked the audience which type of market they would prefer to invest in periodically each year if they didn’t intend to withdraw their money until 10 years from now. I showed them the three charts below and asked them to vote.

Market Behavior Chart A

Market Behavior Chart A

Market Behavior Chart B

Market Behavior Chart B

Market Behavior Chart C

Market Behavior Chart C

 

 

 

 

 

You probably won’t be surprised to learn that Behavior Chart A  was the vote’s biggest winner while Behavior Chart C  garnered the fewest votes. However, you may be surprised to discover that Behavior Chart C  actually displays the best market to invest in and Behavior Chart A  is the worst.

 

You Can Make Money in a Volatile Market

Let’s drill into the numbers associated with each chart.

In Table 1 we display the price and number of shares of an index-based ETF that an investor might buy in a steadily rising stock market if she were to invest $1,000 on Jan. 2nd each year for the next 10 years:

 

Table 1: Annual Purchases in a Steadily Rising Market (Chart A)

PURCHASE DATE AMOUNT INVESTED ETF PURCHASE, PRICE/SHARE NUMBER OF SHARES PURCHASED
JAN. 2, 2015 $1,000 $100 10.00
JAN. 2, 2016 $1,000 $140 7.14
JAN. 2, 2017 $1,000 $180 5.56
JAN. 2, 2018 $1,000 $220 4.55
JAN. 2, 2019 $1,000 $260 3.85
JAN. 2, 2020 $1,000 $300 3.33
JAN. 2, 2021 $1,000 $340 2.94
JAN. 2, 2022 $1,000 $380 2.63
JAN. 2, 2023 $1,000 $420 2.38
JAN. 2, 2024 $1,000 $460 2.17
JAN. 2, 2025 $1,000 $500 2.00
TOTAL SHARES  ________  __________ 46.55
VALUE AT THE END OF 10 YEARS ________ ___________ $23,275.49

As you can see our investor will own 46.55 shares of our hypothetical ETF, which will be worth $23,275.49 when she’s ready to liquidate her portfolio on the 10th anniversary.

Now imagine if our investor faced a rising but volatile market over the next 10 years. Table 2 displays the purchase price per share and the number of shares purchased for the same hypothetical ETF:

 

Table 2: Annual Purchases in an Increasing but Volatile Market (Chart B)

PURCHASE DATE AMOUNT INVESTED ETF PURCHASE, PRICE/SHARE NUMBER OF SHARES PURCHASED
JAN. 2, 2015 $1,000 $100 10.00
JAN. 2, 2016 $1,000 $160 6.25
JAN. 2, 2017 $1,000 $140 7.14
JAN. 2, 2018 $1,000 $250 4.00
JAN. 2, 2019 $1,000 $200 5.00
JAN. 2, 2020 $1,000 $330 3.03
JAN. 2, 2021 $1,000 $280 3.57
JAN. 2, 2022 $1,000 $400 2.50
JAN. 2, 2023 $1,000 $370 2.70
JAN. 2, 2024 $1,000 $450 2.22
JAN. 2, 2025 $1,000 $500 2.00
TOTAL SHARES  ________  __________ 48.42
VALUE AT THE END OF 10 YEARS  _______  __________ $24,209.76

On the 10th anniversary she will own 48.42 shares of our hypothetical ETF, which will be worth $24,209.76 when she’s ready to liquidate her portfolio. Interestingly investing at a constant clip in a rising volatile  market leads to greater value than investing at a constant clip in a steadily rising market.

In Table 3 we display the price and number of shares of an index-based ETF an investor might buy in a steadily declining stock market if she were to invest $1,000 on Jan. 2nd each year for the next 10 years:

 

Table 3: Annual Purchases in a Declining Market (Chart C)

PURCHASE DATE AMOUNT INVESTED ETF PURCHASE, PRICE/SHARE NUMBER OF SHARES PURCHASED
JAN. 2, 2015 $1,000 $100 10.00
JAN. 2, 2016 $1,000 $95 10.53
JAN. 2, 2017 $1,000 $90 11.11
JAN. 2, 2018 $1,000 $85 11.76
JAN. 2, 2019 $1,000 $80 12.50
JAN. 2, 2020 $1,000 $75 13.33
JAN. 2, 2021 $1,000 $70 14.29
JAN. 2, 2022 $1,000 $65 15.38
JAN. 2, 2023 $1,000 $60 16.67
JAN. 2, 2024 $1,000 $55 18.18
JAN. 2, 2025 $1,000 $500 2.00
TOTAL SHARES  _______  _________ 135.75
VALUE AT THE END OF 10 YEARS ________  _________ $67,877.14

Shockingly this third scenario leads to the greatest value upon liquidation – by far. That’s because in effect you’re buying the ETF at a steep discount. It doesn’t matter that the ETF declined during your investment period. All that matters is what it’s worth at the end of the day when you’re ready to liquidate your account.

Screenshot_2014-11-10_15.25.55

The Bottom Line

The point of our example is interim volatility doesn’t matter; the volatile market actually works to the investor’s advantage because it gives her opportunities to buy at the dips. That doesn’t mean you should wait for a volatile market to invest, because it’s almost impossible to time the market. The lesson is you should ignore the behavior of the market if you intend to invest steadily and don’t plan on touching the vast majority of your account value for a number of years.

Markets generally rise over time. So if your investment horizon is fairly long (at least 5 years) then what happens in between doesn’t matter very much as long as your portfolio is ultimately worth more than what you paid for it.

People Are Driven by Fear of Loss

So what accounts for these fears? In the case of volatile markets, Prof. Meir Statman, a member of Wealthfront’s investment team has argued that people tend to extrapolate from their previous experiences of investment loss and apply these emotions to the present day. A market drop, even a fairly small one, brings up investors’ memories of loss, probably from the 2008 financial crisis. Investors then conclude, based on the emotional memory, that their outcome will be just as bad as it was in 2008 – when most everyone lost money.

That simply is not the case: There is no reason to believe that this period of volatility signals a big market drop. (Remember: No one can effectively predict big market drops). Thus, the emotion of fear – specifically fear of investment loss – hampers investors’ rational judgment.

Vivid Memories Overly Affect Your Judgment

We hope this post, which was inspired by an example cited in Elements of Investing, by our CIO, Burt Malkiel and Charley Ellis, a member of our investment team, shows how little effect current market conditions have on the eventual outcome of your investments. What’s important is making a schedule of regular investments and sticking to it.

Some millennials may be particularly prone to fears about investing, especially because their experience with investing was established during the aftermath of the 2008 financial crisis.

If you let fear keep you from investing, you will miss out on years of returns and more importantly the value of compounding, which is greatest when you are young.

Refraining from investing in a volatile market is yet another example of how what feels right isn’t necessarily the right thing to do when it comes to investing. Let your rational mind guide you: Don’t let your fear of loss take control.

 


Disclosure

The information contained in the article is provided for general informational purposes, and should not be construed as investment advice. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront clients. Past performance is no guarantee of future results.

Tags: , , , , , , ,

Questions? Email knowledgecenter@wealthfront.com