In 1991, researchers at the University of Illinois tested 20 pilots in a flight simulator. These pilots all flew by visual flight rules, meaning they only flew when weather conditions were clear enough to see the ground and other aircraft. They didn’t know how to use flight instruments. When the researchers created poor visual conditions, all 20 pilots crashed—in an average of 178 seconds. Next, pilots were given two hours of instrument training. After the training, all the pilots flew successfully.

Likewise, you want your clients to navigate successfully through periods of volatility. But without historical perspective, when the market starts plunging, they’ll be tempted to make decisions that could hurt their long-term results. Help them to see how volatility should be expected and how it can even be an investment opportunity.

Clients desire consistent market returns

Most investors desire more consistency than the chart in Figure 1 demonstrates. Given that the S&P 500 Index¹ had an average annual return of 11.81% from 1980 through year-end 2019, many investors may expect a similar return in an individual year. However, the index returned between 9% and 12% annually only three times during that time period. Usually, it was above or below the average annual return of 11.81%, sometimes significantly.

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 11.81% 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.

Two different historical approaches to volatility that led to an $932,774 difference in outcomes

In Figure 3, each investor started with $10,000 invested on 12/31/79 into the S&P 500 Index. However, the opportunistic investor invested more each time the market dropped 8% or more in a month and the apprehensive investor shifted assets to safer investments 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.)

Despite the growth potential of equities, clients may still fear Market Drops

Let clients know that there have been seven bear markets from 1980–2019.⁶ The seventh and most recent bear market began in March 2020. The previous six averaged a little under one year in length and the average decline was 35%.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 12/31/1979, the S&P 500 Index was at 107. On 12/31/2019, the S&P 500 closed at 3,230,⁸ which is 30 times higher than it was at the end of 1979.

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% in a month, the 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

First, clients desire consistent returns. But in the short-term, returns can be quite volatile. Second, looking at short-term volatility from a long-term perspective can change its significance completely. Third, 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, lack of 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.