Fear and Loathing in Volatile Markets

Lately, we’ve seen wide, uncomfortable swings in the stock market – which have only been exasperated by the recent warmongering between Russia and Ukraine. Back in January, the market’s overall value fluctuated 5% in a single day; and by January 27th folks’ portfolios had lost nearly 10% of their value since the beginning of the year. Scary stuff, right? With such drastic fluctuations occurring on a regular basis, what are the impacts on those of us saving for the future?

Before we jump straight into the numbers, let’s first get some perspective. Volatility means movement. It’s human nature that we worry only when the direction it’s trending is down. The \”melt-up\” we experienced in the second half of 2021 was volatility at its most enjoyable, with the market rising 15% in less than six months. The lousy January we just finished was the other side of the same coin, which is to say, expected. 

Back in November, noted investor Jim Paulsen said, “We are way overdue for a [10% to 15%] correction, and we’re going to get one.” It took only 2 months for Paulsen, the chief investment strategist of the highly regarded Leuthold Group, to be proven right. And although such declines can be great for creating “buying opportunities” – that is, being able to pay significantly less for an investment than one would have a few weeks previous – are you really getting a value, or are you catching a falling knife? In real-time, it’s hard to know.

Buying Opportunity or Catching a Falling Knife

What happens when a 10% decline turns into a 20% decline? Trying to time investments that coincide with a bottom is famously difficult. You don’t want to react too quickly and grab for something that might cut you back.

Not to mention, the funds necessary to make such a purchase have to come from somewhere. If, like many, you don’t keep stacks of money in your mattress or savings account, then buying opportunity or not, it’s difficult to participate in the big stock-market clearance sale.

This conundrum is why we believe in dollar-cost averaging. If we are regularly contributing to our investment accounts, preferably with automatic deposits, then we will participate in the bottom whether we intend to or not.

Either way, the real question is what does the current volatility we’re experiencing foretell? Investors are concerned that the gains we’ve become accustomed to may no longer be realistic. The widely repeated maxim that the stock market returns, on average, 10% per year may no longer be true, and expectations of significantly lower gains in the future are prominent.

Let’s look at the numbers, then, and try to measure the possible effects.

Modeling Declines in Assumed Rates-of-Return

Below is a model for a 35-year-old who is currently projected to have $180k in assets at age 90. The assumed rate-of-return from age 35 until 65 is 6% – after 65 it’s 3%. 

Now let’s insert a 5-year period, from age 40-45, where returns decline to just 2%. As you can see, $140k in value was lost. 

Now let’s assume the decline lasts for a decade instead. Hint: the results are not good.

By having a sustained 10-year period where rates-of-return are reduced, this individual has gone from a nearly $200k surplus to a $100K deficit – worse yet, their funds are completely exhausted by age 80.

The question now becomes – how realistic are these assumptions, and should I be worried?

Volatility at Different Ages – Understanding \’Sequence Risk\’

Sequence Risk comes from the order in which you experience different investment returns. Market declines in early years significantly reduce a portfolio’s longevity compared to the same declines occurring at a later period.

Rather than make broad assumptions as we did in the previous models – to really understand the impact of declining rates of return as well as different possible timings on when those declines may occur, we use a technique called Monte Carlo Simulation. Very briefly, Monte Carlo is a mathematical technique that randomizes changes to baseline assumptions within certain boundaries, and it does this hundreds or thousands of times. The result is a “chance of success” – it answers the question, “What are the odds l will have funds throughout my life?”

Taking the previous model above and running a Monte Carlo simulation, we can see that although the assumptions we inserted made the future seem bleak – it turns out, those assumptions were not very good ones!

Looking at the results, this individual has a 92% chance of having funds throughout their lifetime, and while it’s not 100%, very few things in life are.

So yes, volatility is up. And we may very well be entering a period of declining returns, but there are tools to help us make sense of those impacts – to judge them through a long-term lens and to get a sense of the odds. Doing so may help us worry a little less about the current situation and calm some of those nagging fears. Markets simply do this, and they will do so multiple times over your investing lifetime. It’s important to keep it all in perspective, and not to make decisions based solely on the trumpeting of scary numbers on the internet.

*No information contained here should be considered investment advice. All financial information is solely for educational purposes. Please see a professional for personal investment advice.