Expect the unexpected – that was the key lesson from 2016. Following what many considered to be an uneventful 2015, the market certainly added some excitement for investors. In fact, 2016 began by setting a new record for the worst start to a calendar year in market history! Of course, that simply set the stage for a sharp reversal – the remainder of the first quarter produced the biggest quarterly comeback since the Great Depression.
The volatility of the first quarter was soon forgotten as new world events took center stage. The U.K.’s decision to leave the European Union caused another sharp reaction across markets in June. In the immediate aftermath of the Brexit vote, the S&P 500 Index fell 5.3%, but then quickly roared back 6.5% to surpass its previous high.
Post-Brexit, attention quickly shifted to a heated U.S. presidential election. Investors were so caught off guard by the ultimate outcome that they didn’t know whether to buy or sell: As the election results came in, Dow Futures dropped 900 points overnight before completely reversing course and closing more than 200 points ahead by the end of the trading day.
Putting the Drama in Perspective
As evidenced above, 2016 was a year of some dramatic twists and turns. And it’s the market’s unexpected twists and turns that represent the greatest risk to investors. The risk is not that the market declines in value, it’s that the twists and turns cause panic and destructive investor behavior.
Often the best antidote for panic is preparation. For investors, there is no better preparation than knowing market history. And, believe it or not, if we set the headlines aside and examine 2016 market volatility through an objective lens, we find it was a very normal year.
Cliff Asness, founder of AQR Capital Management, makes this case strongly in his recent blog, “2016 Was Not a Particularly Volatile Year.” Of the data presented, perhaps the most compelling is the annualized daily volatility of the S&P 500 Index. Annualized daily volatility is simply a measure of variation in price, technically referred to as standard deviation. For 2016, annualized daily volatility was 13.1%. Going back to 1946 (since WWII), this falls at the 54th percentile – meaning 46% of annual periods since 1946 have produced greater daily volatility.
As an additional measure of volatility, Asness divides the S&P 500’s high by its low. For 2016, that was 24.2% (the December high divided by the February low). Over the same post-war period cited previously, this data point falls in the 49th percentile.
While the drama of 2016 created what seemed like a very tense, rollercoaster ride in the markets, it was actually a relatively normal year that produced solid returns. And for investors who not only weathered the storms, but capitalized on them, performance was even stronger.
Volatility Creates Opportunities
Even in an average year for volatility like 2016, the natural price swings of the market create opportunities to enhance returns through systematic portfolio rebalancing. The phrase “disciplined rebalancing” shows up often in our Quarterly Insights, but it’s not just an idea to which we give lip service.
During 2016, Truepoint improved portfolio performance through timely rebalancing trades, particularly in emerging market stocks (EM). As expected, volatility of EM was greater in 2016 than it was for U.S. stocks. Following a 10% decline in January, EM climbed all the way to a positive 20% return by September. Truepoint’s investment approach, which is rooted in patience, discipline and the avoidance of emotional mistakes, led us to rebalance into EM in January as selling investors drove the prices lower.
To quantify the value of our opportunistic rebalancing, we compared actual client returns with the general return of the EM fund. The results are compelling, though not surprising. The average return realized by our clients in the EM fund, Dimensional Emerging Markets Core Equity (DFCEX), was 13.5%. This is a full 1.2% higher than the general fund return of 12.3%. This means that our process of buying more of the fund when it declined, and selling some as its price surged, improved the return more than one percent compared to investors who simply bought-and-held without rebalancing.
While the logic of opportunistic rebalancing is clear (buying low and selling high), disciplined execution is rare among investors because of the psychological challenges it poses. In fact, most investors do the opposite – detracting from the fund’s return through their emotional buying and selling behavior. This performance differential is commonly referred to as the “behavior gap.”
Stocks: A Look Ahead
The common explanation for the recent surge in U.S. stocks is that the new administration will deliver economic stimulus, de-regulation and lower corporate taxes. These activities will boost earnings, thereby justifying higher prices today. At least that’s the theory. But the details of President-elect Trump’s fiscal stimulus plan remain unclear, as does the likelihood of the plan being accepted by conservative Republicans.
By contrast, investors may be too bearish on international stocks. The economic data for December suggest this may have been the best month for global manufacturing in over five years. And while the U.S. is nearing full employment, overseas there is still room for growth in both employment and productivity. Plus, international stocks remain cheaper than U.S. stocks by nearly all measures of fundamental valuation.
Bonds: A Look Ahead
The Federal Reserve concluded its final meeting for the year in December and announced its decision to raise the federal funds target rate from its range of 0.25%–0.50% to 0.50%–0.75%. In anticipation of the announcement, bond prices fell throughout most of the fourth quarter. In spite of the sudden and relatively severe decline, the Truepoint bond portfolio finished positive for the year. Furthermore, while the increase in yields had a negative impact on bond returns near year end, the expected return for bonds going forward has increased given the now-higher yields.
Should rates continue to rise, as we expect they will, keep in mind that the high-quality, short-to-intermediate term nature of Truepoint’s fixed income holdings limits exposure to rising interest rates.
Turning the Page from 2016
Despite all the drama that unfolded during 2016, it was a year worth celebrating for investors who captured solid returns while capitalizing on the opportunities inherent in the market’s volatility. That said, the uncertainty that drove the volatility in 2016 is likely to carry into 2017.
And whenever uncertainty is high, intelligent-sounding predictions about the economy and the market abound. Understandably, many investors are naturally drawn to such forecasts in hopes of making enlightened investment decisions. Inevitably someone’s forecast will be right, but evidence shows clearly this should be attributed to luck rather than skill.
The lesson we should take from 2016 is that the world continues to be unpredictable. Fortunately, accurate predictions are not the basis of investment success; patience and discipline are. As the markets teach us time and again, a buy-hold-and-rebalance approach will serve long-term investors well, no matter what surprises 2017 may bring.