Sgt. Barnes

  By Guest Blogger Doug Rowat

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There are investment lessons to be found in the most unlikely of places.

Take, for instance, the first 20 seconds of this rather intense scene from Oliver Stone’s Platoon.

As Sgt. Barnes helpfully pointed out to that young soldier, it’s often in one’s best interests to “take the pain” even when—and sometimes especially when—the world around is out of control.

And so it is with investing. Quietly absorbing discomfort, particularly major discomfort, is often the best thing for your portfolio results. And what’s the most frequent source of discomfort for investors? Volatility.

There are two main types of volatility. The first is the face-melting kind, which occurs infrequently, say, once every three to five years. Recent examples of this kind of volatility occurred during the European sovereign debt crisis, the surprise Brexit vote and, of course, the Covid-19 crisis. In fact, during the Covid crisis the CBOE Volatility Index (VIX), which measures the magnitude of price change (volatility) on the S&P 500, reached an all-time high of 82.7 in February 2020, eclipsing the previous 80.7 record set during the financial crisis. For some perspective, the VIX, as of this writing, is at about 17. Investors are most likely to make emotional, fear-fueled investment decisions during such periods. This kind of volatility basically amounts to a bullet wound to the chest.

The second kind of volatility is less intense, but occurs with more regularity. Every single year, for example, the S&P 500 experiences intra-year drops. The average intra-year decline over the past 40 years has been about 14%, but it’s sometimes as mild as only 3%. Investors are less prone to make emotional investment decisions during any one of these less-intense volatility periods, but the sheer frequency of them still makes poor investment decisions a constant risk. This kind of volatility amounts to a bee sting, but if you get enough bee stings…

Both types of volatility result in an onslaught of behavioural biases: loss aversion, recency bias, herd behaviour, overconfidence and so on. All of these biases can be combated through balance and diversification, infrequent trading, rebalancing, avoiding incessant media newsflow and seeking professional investment advice.

However, it’s impossible to avoid all the hardship that capital-market investing brings. Sometimes you just have to suffer. And this is difficult, especially when you don’t have assurances that all the suffering will be worth it in the end.

While I can’t guarantee the outcome after the next round of face-melting volatility, I can show you how the S&P 500 has soared past mountains of historical volatility over the last 10 years. It’s also useful to highlight that the S&P 500 continues to advance strongly throughout the current recession (a common occurrence for equity markets):

S&P 500 (blue line, LHS) vs CBOE Volatility Index (red line, RHS) – 10 years

Source: Federal Reserve Economic Data; shaded are – recession

And while I can’t guarantee the outcome after the next, and inevitable, intra-year market decline, I can show you that the vast majority of the time, despite these declines, the S&P 500 ultimately finishes the year in the black:

S&P 500 intra-year declines vs calendar year returns.

Source: JP Morgan Asset Management ; Intra-year drop refers to the largest market drops from a peak to a trough during the year; Returns don’t include dividends

Volatility is unavoidable, but if you give in to it (sell assets) every time it occurs, it will kill your performance. If you can endure the suffering that it inflicts, your portfolio will almost certainly come out the other side of it in a better place.

So, the next time the VIX spikes (and it will), think of Sgt. Barnes leaning over you and take the pain. He’s a horrible SOB, but he’s actually doing what’s in your best interests.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.