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How two reactions to volatility could have led to a $834,038 difference in outcomes

In 1991, researchers at the University of Illinois put 20 pilots into a flight simulator and created poor visibility conditions. All 20 pilots crashed—in an average of 178 seconds. They simply didn’t know how to use the instruments. They crashed because of a lack of understanding. Likewise, your clients' lack of understanding concerning volatility could make or break their financial future.

 

Fear of market drops

To most investors, even those who invest in equities, volatility is something to be avoided. And the market can certainly be volatile from year to year, as the chart below demonstrates. The instinctual reaction to volatile markets can be to get out of equities altogether.

 

Clients desire consistent market returns

Most investors desire more consistency than the chart below demonstrates. Given that the S&P 500 Index1 had an average annual return of 11.07% from 1977 through year-end 2016, many investors may expect a similar return in an individual year. However, the Index returned between 9% and 11% annually only two times during that time period. Usually, it was above or below the average annual return of 11.07%, sometimes significantly.

Figure 1: In the short term, the market appears really volatile
S&P 500 Index Quarterly Returns % (3/31/77–12/31/16)2

p3320-Short-TermVolatility

INDEX PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. For illustrative purposes only. The performance shown is index performance and is not indicative of any investment. Investors cannot invest directly in an index.



Many investors don’t realize that volatility can represent the potential for gain as much as it can represent the potential for loss. More importantly, some investors fail to remember that volatility, whether it be over a day, a week, or a year, historically has been short-term.

 

Looking at short-term volatility from a long-term perspective can change its significance completely

Figure 2 shows the results of that volatility with a $10,000 investment into the same index as Figure 1, over the same time period. Instead of focusing on the shifts, an investor can see the overall effect of the 11.07% average annual return.Creating a portfolio that is properly diversified across several different asset classes and investment styles can also help reduce volatility while still helping clients meet their long-term financial goals.

 

figure 2: The same investment viewed from a long-term perspective
Long-Term Growth: Growth of $10,000 Invested in S&P 500 Index (12/31/76–12/31/16)3

p3320-Long-TermGrowth

INDEX PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. For illustrative purposes only. The performance shown is index performance and is not indicative of any investment. Investors cannot invest directly in an index.



Two different historical approaches to volatility that led to an $834,038 difference in outcomes

Each assumes $10,000 invested on 12/31/76 into the S&P 500 Index. However, the opportunistic investor made additions when the market dropped and the apprehensive investor shifted assets in the face of volatility. Ultimately, the opportunistic investor had a significantly higher investment value at the end. (This is for illustrative purposes only and assumes no taxes or transaction costs.)
 

figure 3: Volatility can provide significant opportunity
Two Hypothetical Approaches to Volatility: Growth of $10,000 Invested in S&P 500 Index (12/31/76–12/31/16)4

p3320-TwoApproaches

INDEX PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. For illustrative purposes only. The performance shown is index total return and is not indicative of any investment. Investors cannot invest directly in an index.



Despite the growth potential of equities, your clients may still fear the big drop

Let them know that there have been six bear markets since 1976.6 They averaged a little under one year in length and the average decline was 33%.7 Historically, the probability of a bear market occurring is only about one in every four years. But what's more important than what happens during these bear markets is what happens after they occur. For example, on 12/31/1976, the S&P 500 Index was at 107. On 12/31/2016, the S&P 500 closed at 2,238, which is 20 times higher than is was in 1976.8

 

The Big Mistake

The apprehensive investor that panicked during times of volatility, shown in orange in Figure 3, enjoyed a less volatile experience but ended up with far less assets than the opportunistic investor. When the market dropped 8%, this apprehensive investor moved 20% of their assets into cash investments. After several of these moves, the investor was completely invested in cash and missed the growth experienced by the opportunistic investor.

 

To summarize:

  • Clients desire consistent returns
  • Looking at short-term volatility from a long-term perspective can change its significance completely
  • Viewing volatility as an opportunity or as a threat can lead to far different results

 

Don’t let clients fly without instruments

When market corrections or bear markets occur, clients may want to get out of the market. Like the pilots flying in the simulator, their lack an understanding may lead to poor outcomes. Empathize with clients experiencing market drops, but help them understand the value of sticking with a diversified portfolio over the long-term.

 


Next Steps:

  1. Today, download or order the Beyond Investment Illusions client brochure below
  2. Within one week, share this brochure with three clients and discuss pages 3-6.
  3. Within one month, ask your Hartford Funds advisor consultant about hosting a Beyond Investment Illusions client event.

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More on helping clients understand the illusions of investing

 

All investments are subject to risk, including the possible loss of principal. Diversification does not ensure a profit or protect against a loss in declining market.

1The S&P 500 Index is a composite of 500 leading companies in the United States.

2Data Source: Morningstar, 3/17.

3,4Data Source: Thomson Reuters, 3/17.

5T-Bills are guaranteed as to the timely payment of principal and interest by the U.S. Government and generally have lower risk-and return than bonds and equity. Equity investments are subject to market volatility and have greater risk than T-Bills and other cash investments. Fixed-income investments are subject to interest-rate risk (the risk that the value of an investment decreases when interest rates rise) and credit risk (the risk that the issuing company of a security is unable to pay interest and principal when due) and call risk (the risk that an investment may be redeemed early).

6,7,8Data source: Ned Davis Research, 2016.

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