Market Volatility

The Uncertainty Paradox

 Doubt is not a pleasant condition, but certainty is an absurd one.    — Voltaire

“The market hates uncertainty” has been a common enough saying in recent years, but how logical is it? There are many different aspects to uncertainty, some that can be measured and some that cannot. Uncertainty is an unchangeable condition of existence. As individuals, we can feel more or less uncertain, but that is a distinctly human phenomenon. Rather than ebbing and flowing with investor sentiment, uncertainty is an inherent and ever-present part of investing in markets. Any investment that has an expected return above the prevailing “risk-free rate” (think T-Bills for US investors) involves trading off certainty for a potentially increased return. 

Consider this concept through the lens of stock vs. bond investments. Stocks have higher expected returns than bonds largely because there is more uncertainty about the future state of the world for equity investors than bond investors. Bonds, for the most part, have fixed coupon payments and a maturity date at which principal is expected to be repaid. Stocks have neither. Bonds also sit higher in a company’s capital structure. In the event a firm goes bust, bondholders get paid before stockholders. So, do investors avoid stocks in favor of bonds as a result of this increased uncertainty? Quite the contrary, many investors end up allocating capital to stocks due to their higher expected return. In the end, many investors are often willing to make the tradeoff of bearing some increased uncertainty for potentially higher returns. 


While the statement “the market hates uncertainty” may not be totally logical, it doesn’t mean it lacks educational value. Thinking about what the statement is expressing allows us to gain insight into the mindset of individuals. The statement attempts to personify the market by ascribing the very real nervousness and fear felt by some investors when volatility increases. It is recognition of the fact that when markets go up and down, many investors struggle to separate their emotions from their investments. It ultimately tells us that for many an investor, regardless of whether markets are reaching new highs or declining, changes in market prices can be a source of anxiety. During these periods, it may not feel like a good time to invest. Only with the benefit of hindsight do we feel as if we know whether any time period was a good one to be invested. Unfortunately, while the past may be prologue, the future will forever remain uncertain. 


In a recent interview, David Booth was asked about what it means to be a long-term investor: 

“People often ask the question, ‘How long do I have to wait for an investment strategy to pay off? How long do I have to wait so I’m confident that stocks will have a higher return than money market funds, or have a positive return?’ And my answer is it’s at least one year longer than you’re willing to give. There is no magic number. Risk is always there.”

Part of being able to stay unemotional during periods when it feels like uncertainty has increased is having an appropriate asset allocation that is in line with an investor’s willingness and ability to bear risk. It also helps to remember that, during what feels like good times and bad, one wouldn’t expect to earn a higher return without taking on some form of risk. While a decline in markets may not feel good, having a portfolio you are comfortable with, understanding that uncertainty is part of investing, and sticking to a plan that is agreed upon in advance and reviewed on a regular basis can help keep investors from reacting emotionally. This may ultimately lead to a better investment experience. 

Recent Market Volatility

We Should Expect Volatility

It is important to remember how well-functioning capital markets work and what prices reflect; prices reflect the aggregate expectations of market participants. Risk aversion, investors’ tastes and preferences, and expectations about future profits are among the many inputs that affect aggregate expectations. We should expect these inputs to vary day-to-day. This implies we should expect aggregate expectations to vary from day-to-day. Markets adapt to changing expectations and new information. As a result, we expect prices, as well as the level of volatility, to fluctuate. It is interesting to think of the alternative: If prices did not adjust and remained constant, we would be concerned that markets were not functioning properly.


Do returns during January provide information about returns during the remainder of the year? As we would expect over any period, prices in January 2016 changed from day-to-day as aggregate expectations changed and investors processed new information. During the month, the S&P 500 Index had a return of −4.96%, the ninth lowest return for the index since 1926. The first two weeks of January was the worst start to the year for the S&P 500 in history, with the index returning −7.93% from January 4–15.

Based on this information, some investors may wonder whether the returns in January have some predictive power for the returns during the remainder of the year. Exhibit 1 shows the returns of the S&P 500 Index for the month of January compared with the subsequent 11-month return (i.e., February through December). We find that a negative January was followed by a subsequent 11-month return that was positive 59% of the time, with an average return of 7%, indicating a negative January does not predict poor market returns for the rest of the year.

One additional note: if we look at the five lowest January returns, excluding January 2016, the average return for the remainder of the year was 13.8% and none of these years finished in the lowest 20 years of annual returns for the S&P 500 Index.

Previous Market Declines

What have we seen during previous market declines? As mentioned above, the YTD return for the S&P 500 through January 2016 was −4.96%. From the previous high on November 3, 2015 through its low on January 15, 2016, the S&P was down −10.43%, its second decline of at least 10% since the beginning of August 2015. We can look at the data in Exhibit 2 to see how the US market has performed in subsequent periods following different magnitudes of decline. The exhibit looks at previous times when the S&P Index has declined by 10% and 20%, and shows the subsequent one-, three-, and five-year return. Independent of the magnitude of decline, on average, the return of the S&P 500 over the periods referenced has been positive and greater than the long-term average of 10.02% in half of the time periods observed. The chart also provides information on developed ex US and emerging markets, where we have seen similar results.


Is the recent period abnormally volatile? For the period January 1926 to December 2015, the S&P 500 had a compound return of 10.02% and a standard deviation of 18.85. Looking over a more recent period, from January 2010 through December 2015, the return for the S&P 500 has been 12.98% with a standard deviation of 13.09. Comparing these results with other historical periods, we can see the recent period has not necessarily been more volatile. During the so-called “Lost Decade” from January 2000 to December 2009, the S&P 500 Index had a compound return of −0.95% and an annualized standard deviation of 16.13. When we continue to look at the data in Exhibit 3, grouped by decade starting in January 1930, we see periods of higher and lower returns as well as periods of greater and lesser volatility.

Importance of Discipline

While in the midst of a market downturn, we may be inclined to look for some type of signal as to what the recent period means for future returns or to assume the current period is somehow different from what we have observed historically. Before jumping to conclusions or attempting to make predictions about what the future may hold, analyzing the available data can provide perspective. It is also important to remember that there is ample evidence that suggests prices adjust in such a way that every day there is a positive expected return on our invested capital. While the realized return over any period may be positive or negative, in expectation we believe markets will go up. As investors, we should remain disciplined through all periods in order to capture the expected returns the market offers.

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