Global stock markets have stumbled since the start of the second quarter as the Chinese economy slowed, the euro zone crisis escalated, and U.S. manufacturing and employment gains tapered off. The decline in stock prices has been accompanied by sharp increases in volatility.
Over the past two months the S&P 500 index, which was up nearly 13% for the year as of April 1st, has given back more than half of this year's gains. In foreign markets, both the international developed (MSCI EAFE) and emerging market (MSCI EEM) indexes, which were up were close to 11% and 14% respectively, have given up all their gains and then some.
The price correction has raised concern among some investors that 2012 could turn out to be a replay of 2011, when the cumulative effect of Japan's disasters, the European sovereign credit crisis, mid-year U.S. recession risks, and the Federal debt ceiling impasse in congress left the S&P 500 price Index unchanged and the foreign markets in deep negative territory at the end of the year.
The high volatility is a result of the current market anxiety. Are these conditions likely to remain high in the near future? Can we make accurate predictions about future returns based on volatility? And how does all this affect investors?
Implications for Investors
Investors who believe they can accurately time markets or pick stocks should welcome periods of high volatility as these periods provide ample opportunities to distinguish themselves from their competitors.
Periods of high volatility should be ideal for market timers and stock pickers who attempt to get in and out of risky asset classes at the appropriate times and who purport to use their skills, whether real or perceived, to pick out winners and avoid (or even short) losers.
On the other hand, more realistic investors choose to mitigate risk in periods of high volatility by being widely diversified across all asset classes, including international equities and fixed income and by being broadly diversified within asset classes.
The sharp decline in equity prices that we have seen since the start of the quarter has been accompanied by an equally sharp increase in volatility. This is expected as periods of higher-than-average volatility have been historically associated with periods of extreme negative performance.
Because volatility is auto-correlated, in the short run, it is likely to continue. However, the variable does not have any predictive power over future returns. In fact, in subsequent periods and years, following periods and years of extreme negative performance, returns have been, on average, positive.
Furthermore, asset pricing theory puts forward that expected investment rewards should increase in challenging times; a result that is generally confirmed by the empirical evidence.
Further still, previous research has shown that, contrary to a common misconception, realized investment returns are not reliably negative during difficult economic times, and that attempts to time allocations to risky assets at different market moments are likely to be pointless and detrimental to performance.
Volatility breeds anxiety. The best way to mitigate the worry is to be broadly diversified within and across asset classes at all times, so one is always positioned to earn the returns of those asset classes when the markets turn.