Education:Courses
The analysis of the stock market volatility and ways to mitigate the risk
2021-03-01
Enter your email address to follow ECNFIN.com and receive notifications of new articles by email for free. Be the first to read and do not miss future timely research publications.
Sign Up
Enter your email address to follow ECNFIN.com and receive notifications of new articles by email for free. Be the first to read and do not miss future timely research publications.
Abstract:
Oftentimes a successful investing requires the time commitment, ability, and wiliness to take risk. When it comes to the real life, very few investors have the luxury and wiliness to meet these conditions to become successful. In this paper, I analyze the stock market risk and highlight difficulties to remain calm and rational during volatile times. For risk averse investors, one of the solutions is to have a diversified portfolio. The simple 50/50 asset allocation strategy combines a broadly diversified equity index with long-term government bonds. It is one example of a simple diversification strategy.
Paper:
Investing in the stock market can be rewarding. Let’s break down the prior sentence. Definition of investing is to commit (money) in order to earn a financial return (Merriam-Webster dictionary). The key word is to commit. You must commit for a long-term in order to fully benefit from investing. Long-term commitment allows investors to go through ups and downs of the stock market and come out with a positive gain. Sometimes, you need to provide enough time for your investment to be noticed by the rest of the market participants.
However, it is easier said than done. We are all human and have many limitations that may break our commitment to invest and wait. We are all subject to behavioral biases such as loss aversion. Loss aversion expresses the intuition that a loss of $X is more aversive than a gain of $X is attractive (Daniel Kahneman and Amos Tversky, 1984). When investors feel the pain from losing money in the short-term, they may be inclined to sell when the stock market is down. By selling stocks when the market is down, will create realized losses and prevent investors from a future possible recovery.
Another limitation that most investors face is the personal time horizon. Benjamin Franklin wrote before: “in this world, nothing is certain except death and taxes” (Constitution Center). We all have our personal time horizon in terms of living years. However, we do not know for certain the duration of our time horizon. The death is certain, but the exact time is not. We may not guess exactly how many years we may have left. Thus, we cannot know the duration of our lifetime horizon with certainty.
What is required to be a successful investor? First, the stock market requires a long-term commitment to be a successful investor. Second, we are all human and subject to behavioral biases. We may experience loss aversion and sell when the market is down. Third, even if we can control our emotions, we are certain to have the end of our living years at some unknown point. The duration of the living years is uncertain and creates the risk for investors.
What should we do by knowing the requirements, risks and future uncertainty? We can visually and mathematically analyze the stock market risk and come up with a practical solution. Let’s review the performance of the stock market in 2020 and see how you may have reacted or did react. The year 2020 was unique by its high volatility and a very brief stock market correction. During the year we saw a sharp selloff and equally impressive rebound in a very short time period. Thus, the year 2020 is a great case study of what may happen in the future and how one may react.
Let’s try to analyze the risk quantitatively and visually. I will use the standard deviation to quantitatively measure the risk. According the Investopedia: “The standard deviation is a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance.” For the normally distributed data set, one standard deviation of the mean represents about 68%; and two standard deviations represent about 95% of possible outcomes.
If you are invested in the S&P 500 Index or portfolios similar to this index, you had to experience the following risks in 2020. I will use iShares Core S&P 500 ETF ticker IVV as a proxy to the S&P 500 Index. The daily standard deviation for the IVV was 5.92% in March 2020 (see Table 1). This means that on any single day, there is 68% chance that your portfolio can go up or down by 5.92%. Also, there is 95% change that your portfolio can go up or down by two standard deviations or 11.84% on any single day in March 2020. If that does not scare you, lets convert the daily risk to monthly and annual numbers. The monthly standard deviation was 27.79% in March 2020. For one month of March 2020, there was 68% chance that your portfolio can go up or down by 27.79%. By increasing the probability to 95%, there is a change that your portfolio could swing plus or minus 55.58% just in one month. Now let’s convert monthly standard deviation to annualized standard deviation. For the month of March 2020, the annualized standard deviation was 94.05%. If the entire year was similar in volatility to March 2020, there is 68% chance that your portfolio could go up or down by 94.05%. By increasing the probability to 95%, the swing in your portfolio values is between plus and minus 188%.
By closing your eyes and visualizing March 2020 with a wild volatility and unknown future ahead, would you have strength to stay calm and hope for the best? What if the rest of the year was similar to March? That would mean you could have made plus or minus 94% of your portfolio using 68% probability (see Chart 1). Would you be willing to risk it all? Fortunately, we know that the rest of the year was not the same as March 2020 and we saw a nice recovery. However, nobody knows what the future will hold, the next time will be different.
Usually, the stock markets have quick corrections which create attractive valuations and attract new buyers. In reality and under normal circumstances, attractive fundamental values and high dividend yields, attract new buyers. A normal stock market correction does not usually last long. However, sometimes we have prolonged rescissions that can last years; such as, the financial crisis of 2008 or dotcom bobble.
You should be prepared to risk it all and may need to wait multiple years to see your portfolio to recover. For example, the dotcom bobble caused Nasdaq index to rise to 5,048.62 on March 10, 2000. When the dotcom buddle did burst, the Nasdaq fell by 76.81% all the way to 1,139.90 on October 4, 2002. It took about thirteen years for the Nasdaq to return to 5,000 level on July 2015. Some stock market corrections can take a long time to recover from.
Some investors may have the high-risk tolerance and ability to ignore a steep decline in the stock prices. Even these investors face the risk of uncertainty – their own time horizon. As I discussed above, the death will come for certain but when that day will come is everybody’s assumption and guess. Life expectancy is the risk because we cannot predict it with certainty. So even the risk averse investors may not be able to wait for the stock market to recover due to uncertain death.
Investors may be able to control the behavioral bias, such as, loss aversion. Even though, it is very difficult to do even for professional investors. All investors are subject to certain future death with uncertain date. This creates uncertain time horizon. Knowing about these risks, what solutions can investors implement in managing money?
Diversification becomes very important in portfolio construction. A well-diversified portfolio may lower the risk while providing returns on investments. There are many ways to diversify. One simple solution that may work is to combine asset classes that behave differently when the stock market declines. I find that the US Government long-term bonds tend to provide a valuable benefit of a negative correlation to the stock market during economic recessions. I have written about the Simple 50/50 model before. The Simple 50/50 model consists of 50% of the portfolio value invested in the iShares Core S&P500 ETF ticker IVV and the remaining 50% of the value invested in the iShares 20+ Year Treasury Bond ETF ticker TLT. This model was successful at mitigating the downside risk during the financial crisis as well as during the Covid-19 pandemic (Simple 50/50).
First, let’s review the individual risks for the iShares Core S&P500 ETF ticket IVV and iShares 20+ Year Treasury Bond ETF ticker TLT. How much risk did investor assume by holding TLT or IVV during March 2020? The daily standard deviation for the IVV was 5.92% in March 2020 (Table 1 and Chart 1). The daily standard deviation for the TLT was 3.77% in March 2020 (Table 2 and Chart 2). Each selected asset class comes with a significant risk. If you were invested in the IVV, with 68% probability, you would expect your portfolio to be up or down 5.92% on any single day during March 2020. On the other hand, if you put all your money in the long-term government bonds, with 68% probability you would expect your portfolio to be up or down 3.77% on any single day in March 2020. Both equities and government bonds have significant risk by themselves.
However, by combining two negatively correlated asset classes, the entire portfolio risk goes down during the year 2020. The total risk for the Simple 50/50 portfolio is lower than the individual risk of IVV and TLT alone. When I combine both IVV and TLT together and create the Simple 50/50 Model, the total portfolio daily standard deviation falls to 2.57% during the March 2020 (see Table 3 and Chart 3). I was able to lower the risk by 56% in comparison to investing in the IVV only or by 32% in comparison to investing in the TLT only. By creating the portfolio with the two negatively correlated asset classes, I was able to decrease the risk significantly during the year 2020 (see Chart 3).
So far, we have established that diversification can lower overall portfolio risk based on the above analysis of the Simple 50/50 model during the year 2020. However, how does the performance of this model compare to the performance of its components: IVV and TLT? As we know, the year 2020 was volatile but overall positive for the stock market. There was a sharp decline in February and March and equally impressive recovery afterwards (Chart 4). In contrast, investments in the TLT did very well at the beginning of the year and then declined during the second half (Chart 5). Individually, IVV and TLT performed differently on any single month but overall had a good year in 2020. You can visually see how diversification works, when one asset class provides downside protection for another asset class.
Now, let’s analyze the performance of the Simple 50/50 model during the year 2020. This model had lower volatility / lower risk during the year 2020 (Chart 6). The biggest losses were in March 2020, when the Simple 50/50 model lost -2.88% and October 2020 when the model lost -2.95% (Chart 6). In comparison, investments in IVV saw a decline of -12.13% in March 2020 (Chart 4). Also, if you were fully invested in TLT exclusively, your investment was down -5.05% in August 2020 and -3.39% in October 2020 (Chart 5).
Next, I compare the monthly performance of three investments: IVV, TLT, and the Simple 50/50 Model side by side (Chart 7). The Simple 50/50 Model displays less volatility and is positioned in the middle between IVV and TLT (Chart 7). As the saying goes, slow and steady wins the race. It is true for the Simple 50/50 model which outperformed both IVV and TLT in the year 2020 (Chart 8). The total return for the Simple 50/50 model was 19.88% vs. 18.40% for IVV and 18.15% for TLT during the year 2020 (Chart 8).
The Simple 50/50 model is a diversified portfolio with lower risk than its individual components. It also provides equity like potential returns. Because of its lower volatility, this model helps to control the behavioral biases such as loss aversion. Very few investors can stomach monthly volatility of plus or minus 55.58% which is based on the standard deviation for the IVV during March 2020. Even if you can control your emotions, you cannot control your time horizon. The duration of the living years is uncertain and creates the risk. Investment requires a long-term time horizon to be successful. A sharp stock market correction may be followed by a very slow and gradual recovery. It may take years to recoup the losses. Since you may not have the luxury to wait and ability to control your time horizon, the decline in portfolio values may become permanent. A prudent solution for many investors is to have a diversified portfolio with lower standard deviation – risk. One example of such portfolio is the Simple 50/50 model.
Enter your email address to follow ECNFIN.com and receive notifications of new articles by email for free. Be the first to read and do not miss future timely research publications.
Sign Up
Enter your email address to follow ECNFIN.com and receive notifications of new articles by email for free. Be the first to read and do not miss future timely research publications.
References:
Constitution Daily. Benjamin Franklin’s last great quote and the Constitution, https://constitutioncenter.org/blog/benjamin-franklins-last-great-quote-and-the-constitution
Daniel Kahneman and Amos Tversky. “Choices, Values, and Frames.” American Psychologist. Vol. 39, No. 4, p. 341-350. April 1984.
Investopedia, https://www.investopedia.com/terms/s/standarddeviation.asp
Merriam-Webster dictionary, https://www.merriam-webster.com/dictionary/invest
Simple 50/50 Asset Allocation Model – Proven to Withstand the Financial Crisis of 2008, https://ecnfin.com/2012/10/07/simple-5050-asset-allocation-model-proven-to-withstand-the-financial-crisis-of-2008/
The Simple 50/50 Asset Allocation Model – Proven to Withstand the Financial Crisis of 2008 and Covid-19 Pandemic, https://ecnfin.com/2020/09/16/the-simple-50-50-asset-allocation-model-proven-to-withstand-the-financial-crisis-of-2008-and-covid-19-pandemic/
Data:
Yahoo! Finance. S&P 500, IVV and TLT Price Data was retrieved from http://finance.yahoo.com
Disclosures:
The analysis is based on historical data and future expectations that may not be correct. This paper was written as an opinion only. The data is not guaranteed to be accurate or complete. Please consult with your financial advisor, before making an investment decision. Neither ECNFIN.COM nor its author are responsible for any damages or losses arising from any use of this information. ECNFIN.com and its podcast are not associated with nor do they necessarily represent the opinion or advice of Epiqwest Culver Wealth Advisors LLC. Past performance doesn’t guarantee future results.
Subscribe wherever you enjoy podcasts:
Our Mailing Address:
ECNFIN
1312 17th Street
Unit #2991
Denver, CO 80202
Our Fax:
+1 720-790-7606
Our Mailing Address:
ECNFIN
1312 17th Street
Unit #2991
Denver, CO 80202
Our Fax:
+1 720-790-7606
More Episodes
Get this podcast on your
phone, FREE
