Are markets more volatile now? It depends on the market and the asset class in question, but in general the answer is yes at least among equities and diversifier asset classes such as real estate and commodities, as measured by standard deviation. On the other hand, fixed income has seen a slight decrease in volatility overall since 2008.
Why does volatility matter? Because it rattles investors which then affects the relationship between the client and the advisor. Among the many important tasks of a financial advisor, few are more important than navigating clients through an increasingly rocky environment.
Moreover, advisors who rely upon tactical management strategies will find the sledding a bit rougher in markets that are choppier than they have been in the past.
To see how volatility affects returns, I looked at the volatility of monthly returns over the 27-year period running from Jan. 1, 1988, through Dec. 31, 2014. I selected varying time frames to obtain both a longer-run view as well as a pre-2008 and post-2008 view.
PAIR OF COMPARISONS
The first part of the analysis divided the 27-year period into two time chunks: the 20-year period from Jan. 1, 1988, to Dec. 31, 2007; and the seven-year period from Jan. 1, 2008, to Dec. 31, 2014.
The second part of the analysis looked at the volatility of monthly returns during the seven-year period from Jan. 1, 2001, to Dec. 31, 2007 during the lead-up to the last financial crisis and the seven-year period from Jan. 1, 2008, to Dec. 31, 2014.
I examined the monthly returns of 10 asset classes, mostly by using well-known indexes: the S&P 500, S&P MidCap 400, Russell 2000, MSCI EAFE, MSCI Emerging Markets, Dow Jones U.S. Select REIT, S&P Goldman Sachs Commodity, Barclays U.S. Aggregate Bond, and Barclays Global Treasury ex-U.S. Capped, plus the three-month U.S. Treasury bill.
As shown in the top part of the Comparing Volatility chart below the monthly standard deviation of return for the S&P 500 over the 20-year period from Jan. 1, 1998 to Dec. 31, 2007, was 13.51%. Over the most recent seven-year period, it was 16.82% representing an increase in volatility of 24.5%.
U.S. mid-cap equities (as measured by the S&P MidCap 400) saw an increase of 30.4% in monthly volatility during the past seven years. U.S. small-caps (the Russell 2000) experienced a 25.3% increase in volatility since 2008.
VOLATILE REAL ESTATE
Non-U.S. equities, represented by the MSCI EAFE and MSCI Emerging Markets, have seen volatility increase by 30.6% and 12.3%, respectively. But its U.S. real estate (Dow Jones U.S. Select REIT) that has experienced by far the largest increase in monthly volatility of return a whopping 114.3% increase over the past seven years, compared with the prior 20 years.
Commodities tend to be viewed as extraordinarily risky (or volatile), but, as can be seen, the volatility of commodity returns (as measured by the S&P Goldman Sachs Commodity Index) increased by 29.6%. Thats roughly the same as the increase in volatility experienced by non-U.S. developed equities. And the standard deviation of commodities monthly returns is comparable to those of emerging stocks.
As noted above, the volatility of fixed-income indexes has declined in recent years. The volatility of U.S. bond monthly returns (measured by the Barclays U.S. Aggregate Bond Index) decreased by 13.1%, whereas for non-U.S. bonds (as measured by the Barclays Global Treasury ex-U.S. Capped Index) it has decreased by 2.1% in the most recent seven-year period.
U.S. cash (three-month T-bills) has seen volatility decrease by nearly 71%. This is not surprising: Returns on cash have been so low that volatility is naturally also reduced. The size of the change in the volatility of monthly T-bill returns (-70.9%) is exaggerated by the fact that the raw standard deviation figures are very low, so any change produces a large percentage difference.
The first wave of this analysis pitted the volatility of various indexes over a 20-year period against the volatility over the most recent seven-year period. But what do we find if we compare time frames of equal length?
I looked at volatility over the seven-year period from 2001 to 2007 versus the seven-year period from 2008 to 2014; the results are shown in the lower half of the same chart.
In general, a similar story emerges. We see significant increases in volatility over the most recent seven-year period in all the equity and diversifier asset classes compared with the prior seven-year period. The only asset classes that have experienced a decline in volatility have been U.S. bonds and U.S. cash.
The decrease in U.S. bond volatility has been modest (-6.8%), bordering on negligible. The change in the volatility of cash is a large number (-63.5%), but, as noted before, it is an artifact of a very small number to begin with.
At first blush, it may seem that any period involving 2008 will cause volatility to be much higher. That year certainly contributed to higher volatility. But recall that the period from 2001 to 2007 also included two rough years for U.S. equities: 2001 when the S&P 500 lost 11.89% and 2002, when it lost 22.10%.
In fact, 2002 was a rough year for all equity indexes, both domestic and non-U.S. The S&P MidCap 400 was down 14.5%, the Russell 2000 lost 20.5%, the MSCI EAFE was off 11.4% and the MSCI Emerging Markets was down 15.9%. The losses were not as dramatic as in 2008, but they represented serious declines that tend to elevate the standard deviation of return.
WHAT IT MEANS
What does it all mean for advisors?
If tactical market timing in an asset-allocation model has been difficult in the past, its even harder now with increased volatility all of which argues for a strategic approach to asset allocation. At the very least, it suggests we might consider deploying a non-tactical strategic portion of the overall portfolio.
The strategic portion of the overall portfolio would commit to a set number of asset classes and then rebalance back to the assigned allocations on a periodic basis say, annually.
The tactical element of the portfolio then attempts to anticipate asset-class strength and weakness, and allocates accordingly.
Of course, that is easier said than done.
The average annualized performance of a 10-index strategic asset-allocation model (using the indexes already noted) over the past 27 years was 8.99%, with a standard deviation of monthly returns of 10.3%.
This assumes equal weighting to all 10 indexes and annual rebalancing.
Thus, it represents a 70% allocation to equity and diversifier indexes and a 30% allocation to fixed-income indexes.
By comparison, the S&P 500 had a 10.62% annualized return over the 27-year period, but a 14.4% standard deviation of return. The S&P 500 had an 18% higher return but 40% higher volatility of return.
Those overall 27-year results mask the experience over shorter time frames. For example, the S&P 500 had six rolling three-year periods (between 1988 and 2014) with losses the worst being 14.55% from 2000 to 2002.
(Interestingly, the worst three-year rolling return did not involve 2008. One three-year rolling return that did include 2008 running from Jan. 1, 2006, to Dec. 31, 2008 was -8.36% for the S&P 500. From Jan. 1, 2007, to Dec. 31, 2009, the annualized return for the S&P 500 was an even gentler -5.63%.)
By comparison, the 10-asset 70/30 model only had three three-year rolling periods with a loss the worst being 3.83%, from 2006 to 2008.
The strategic, diversified 10-asset model delivered more consistent rolling returns compared with the S&P 500 and with half the number of negative rolling three-year returns.
If consistency of performance is important to clients, you should employ a broadly diversified strategic portfolio.
In summary, increased levels of volatility will continue to test the mettle of market timers.
One solution is to diversify across multiple asset classes in order to reduce overall portfolio volatility.FP
Craig L. Israelsen, a Financial Planning contributing writer in Springville, Utah, is an executive in residence in the personal financial planning program in the Woodbury School of Business at Utah Valley University. He is also the developer of the 7Twelve Portfolio.
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