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In 1991, researchers at the University of Illinois tested 20 pilots in a flight simulator. These pilots all flew according to visual flight rules, meaning they flew only when 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, the pilots were given two hours of flight-instrument training. After the training, all the pilots were able to fly successfully.

Likewise, as an investor you want to navigate periods of volatility successfully. But without historical perspective, when the market takes a dive, you may be tempted to make decisions that could hurt your long-term investment results. But volatility is not only expected, it can also be an investment-growth opportunity.

 

Pereseverance Is Key

When the market doesn’t provide positive returns in a particular year, we often feel uneasy, overlooking the fact that the positive returns only come as an average return over time—not every year.

Naturally, investors desire more consistency than the chart in Figure 1 demonstrates. Given that the S&P 500 Index1 had an average annual return of 12.35% from 1982 through year-end 2021, 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 12.35%, sometimes significantly.



Figure 1: In the short term, the market appears really volatile
S&P 500 Index Quarterly Returns % (1982–2021)2

Past performance does not guarantee future results. For illustrative purposes only. Indices are unmanaged and not available for direct investment.

 

Some investors view volatility as entirely bad, making it difficult to accept that volatility can represent the potential for gain as much as the potential for loss. More importantly, some investors forget that volatility, whether it lasts a day, a week, or a year, has historically been short-term.

 

Looking at short-term volatility from a long-term perspective can change investors' perception 

Figure 2 shows the results of that volatility with a $10,000 investment in the same index as Figure 1, over the same time period. Instead of focusing on the shifts, investors can see the overall effect of the 12.35% average annual return. Creating a portfolio that's properly diversified across several different asset classes and investment types can also help reduce volatility while still helping investors 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 (1982-2021)3

Past performance does not guarantee future results. For illustrative purposes only. Indices are unmanaged and not available for direct investment.

 

Two very different reactions to volatility that led to an $894,314‬ difference in returns

 

In Figure 3, each investor started with $10,000 invested on 12/31/81 into the S&P 500 Index. However, the opportunistic investor invested an additional $2,000 each time the market dropped 8% or more in a month, while the apprehensive investor shifted assets to safer investments. 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 (1982–2021)4

Past performance does not guarantee future results. For illustrative purposes only. Indices are unmanaged and not available for direct investment.

 

Despite the growth potential of equities, market drops can still be uncomfortable

Keep in mind that there have been seven bear markets from 1982–2021.6 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 12/31/1982, the S&P 500 Index was at 141. On 12/31/2021, the S&P 500 closed at 4,766,8 which is more than 33 times higher than it was at the end of 1982.

 

The big surprise

The apprehensive investor who panicked in times of volatility, shown in orange in Figure 3, was able to avoid some of it but also ended up with far less assets than the opportunistic investor. Because 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 "safe" cash, missing the growth experienced by the opportunistic investor.

 

When the market gets rough, remember these three things 

First, it's natural to want 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 instead of a threat can lead to far different results.

 

Don’t fly without instruments

When market corrections or bear markets occur, getting out of the market is tempting. Like the pilots flying in the simulator, not seeing things clearly can lead to poor outcomes. Even though market drops are uncomfortable, there's value in sticking with a diversified portfolio over the long-term.

 

Next Steps

1 Download or order the Beyond Investment Illusions client brochure
2 Within one week, share this brochure with three clients who are nervous about volatility 

 

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Investing involves risk, including the possible loss of principal.

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

2Data Sources: Morningstar and Hartford Funds, 1/22

3,4Data Source: Morningstar and Hartford Funds, 1/22

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 equities. Equity investments are subject to market volatility and have greater risk than bonds, T-Bills, and other cash investments. Fixed-income investments (bonds) 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: Morningstar and Hartford Funds, 1/22

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