There’s been a lot of talk lately about how the market has become more volatile over the past couple years. A lot of talking heads throw this out as if it were a proven fact and use it to justify whatever their call of the day happens to be.
I decided to look at the numbers and see if the doomsayers are right. And while what they’re saying is technically correct (the best kind of correct), we’re simply seeing a return to long-term averages.
Looking at the Data
A good measure of volatility is the standard deviation of daily returns, so I pulled the numbers for three indices in order to look at different time periods.
- Russell 3000 Index (1988 – 2015)
- S&P 500 Index (1950 – 2015)
- Dow Jones Industrial Average (1900 – 2015)
The Russell 3000 is a good representation of the total US stock market, but we don’t have a huge amount of data to look at. The Dow Jones Industrial Average isn’t a particularly great representation of the US market, but it allows us to look back in time a lot further than would otherwise be possible. The S&P 500 is right between the two.
What does the Long Term Data Look Like?
Let’s look at the Russell 3000 Index first:
As you can see, it’s full of peaks and valleys and looks pretty jagged.
Once we fit the trend line, we can see that there really is no long-term trend. The slope of the line, which tells us if the market is tending to get more or less volatile through time, is 0.0002 – basically 0.
If the trend line is to be believed, we should expect the standard deviation of the daily returns of the Russell 3000 Index to go up by 0.02 percentage points per year. At that rate, it would take a little more than 50 years for the standard deviation to go up one percentage point.
That’s already what I would call “slim to none,” but the statistical measure of how well the trendline describes the data – called the R2 – is 0.092, which is very low. Basically, it’s telling us that the trendline explains about 9% of the variation in the data. The other 91% of the variance is random noise, or at least it is explained by other factors.
To be clear (and I can already hear the statisticians out there pulling out their hair), this is an approximation. The math is a little bit more nuanced, but suffice it to say, we don’t find much evidence that the US stock market (as defined by the Russell 3000 Index) is getting more volatile through time.
What about the S&P 500?
Well, we see pretty much the same thing. The slope of the trend line is 0.00009 – even closer to 0 than the Russell 3000. So instead of the standard deviation of the daily returns going up by one percentage points every 50 years like with the Russell 3000 Index, it would go up by one percentage point every 111 years or so.
That being said, the R2 is twice as high, though it was starting from a pretty low level. The trendline explains about 18% of the variation of the data for the S&P 500 Index. Again, this is basically telling us that over the long term the markets are not getting any more volatile through time.
On to the Dow…
Again, we’re looking at the same thing. A trend line that is all but 0 – though in this case the trend line is actually slightly negative (-0.000009) – and an R2 that says the data is pretty much noise.
What About Short-Term Volatility?
We see obvious spikes in the standard deviation of daily returns when the markets are going down – when the markets are in turmoil, changes occur quickly – which is what a lot of people are worried about.
|Year||Russell 3000 Index||S&P 500 Index||Dow Jones Industrial Average|
|Long Term Average||1.03%(1988 – 2015)||0.89%(1950 – 2015)||0.97%(1900 – 2015)|
The standard deviation of daily returns rose in 2014 and 2015. However, they were starting from a really low level.
Yes, volatility increased across all three indices, but even in 2015 the standard deviation was right at the long-term average. So with everything we saw last year – from China, to Greece (and the all of the other problems in the European Union), and everything else – we had a year with basically average volatility.
In other words, while we experienced a small increase in the volatility of the market over the past couple years, we’re actually just getting back to the long-term average level of volatility.
What Does This Tell Us?
Markets move. That’s what they do. It’s easy to forget just how much. Since 2012, we have seen daily standard deviations under 1%. That’s pretty calm. Now that we’re seeing volatilities around their long-term averages, people are acting as if the markets are coming apart at the seams.
There are a whole bunch of reasons for this, but I see two main issues:
The Financial Media – The media needs big events to happen. Volatility drives sales and revenue, so they hype up every move the market makes – up or down.
Our Own Nervousness Around the Stock Market – We last dealt with a down market in 2008. Before that, it was the dot com crash in the early 2000’s. Those kinds of memories leave a bad taste in your mouth and, for most people, those are our mental models of what a down market looks like. So anytime the markets hint at a less-than-stellar year, we immediately assume a crash is impending.
We’ve had a really strong market for the last seven years. Since 2008, the S&P 500 Index has been positive every year – and some of those years were really positive. The pessimists are waiting for the other shoe to drop. Whatever their reasons – whether they think China is going to fall apart, valuations are too high, or the bull market has simply run it’s course – they think we’re “due” for a bad turn.
Thanks to market events over the last 20 years, our minds think a “bad turn” means “crash.” It doesn’t work like that. You can’t predict what the market will do. Even if we did know that the markets were going to drop, that doesn’t necessarily mean it’s going to crash.
DC to Philadelphia via San Diego
Volatility is an inescapable part of the market, but most of the day-to-day noise comes out in the wash. Last year, the Dow Jones Industrial Average was down 398.04 points (-2.23%). Not a good year, but moderately flat – not much motion when viewed in historical context.
But what if we zoom in and look at the daily movements? The sum of the absolute value of each day’s movement for the year was 31,839.34 points. So the market moved almost 32,000 points only to wind up less than 400 points away from its starting point. That’s roughly the equivalent of driving roundtrip from DC to San Diego – twice – just to get to Philadelphia.
The average daily movement of the Dow was 126.85 points, meaning on an average day last year, the Dow moved a little less than one-third of its total annual return (126.85/398.04 = 0.32). The fact that the Dow was down about 400 points for the year simply means there were a couple more bad days than good days last year.
So What Should I Do?
When you hear these daily movements on the radio every day coming home from work, it’s easy to forget that almost all of what we hear is noise. If you are investing for the long term and focused on the long term, daily moves are pretty much meaningless. The markets being up or down 2% next Thursday has all but zero bearing on your long-term finances.
What matters is disciplined investing and sticking to your plan. Once you build a financial plan that takes you from where you are today to where you want to be, stick with it. That doesn’t mean you should stick your head in the sand and only come back out when it’s time to retire, but it also doesn’t mean you should worry about all the short-term noise.
One of the keys to staying disciplined is making sure to build your portfolio around your risk tolerance. You need a portfolio that will let you weather all the ups and downs of the market. Staying disciplined isn’t always easy, but if you are taking the right amount of risk, and know what you are investing towards, it gets a lot easier.
S&P 500 Index and Russell 3000 Index data courtesy of Yahoo! All Dow Jones Industrial Average data provided by Samuel H. Williamson, ‘Daily Closing Value of the Dow Jones Average, 1885 to Present,’ MeasuringWorth, 2016. Driving distances from Google Maps. Driving distance from our office in Tysons Corner, VA to San Diego CA is 2,680 miles, and the driving distance from our office in Tysons Corner, VA to Philadelphia, PA is 150 miles.