Expect Market Volatility and You'll Win

Since World War 2, stockmarkets have fallen by 20% or more on 17 occasions. You would think an event which, on average, occurs every 5 years would be considered quite common. Yet every time markets fall, the media whips up anxiety because ‘it’s different this time’.

Imagine the difference to your investing experience – and your investment returns – if you accept sharemarket volatility as the price of admission for growing your wealth.

Almost every adult Australian has a super fund, which means (sadly) there are many uneducated super fund members in our community. In early 2020 when we were all introduced to the uncertainty of a global pandemic, the Australian stockmarket fell 35% in just 22 trading days.

During these months, more than 500,000 super fund members contacted their fund to switch to their fund’s ‘cash’ or ‘defensive’ option[i]. About 25% of these members still have not switched back to the option they had before.

You may recall from late March 2020, markets started to bounce back. Between 20 March and 30 June 2020, the Australian stockmarket was up 7%. Even accounting for market volatility in 2022, since 1 July 2020 the Australian stockmarket is up a further 20%.

One fund researcher estimated that super fund members who switched from ‘balanced’ to ‘cash’ on 31 March 2020 produced a return of -9.7% 12 months later. For members who stayed the course and did nothing, their return was +15.1%. In other words, the member who did nothing had a portfolio balance 25% higher.

The graph below is a reminder that in almost every calendar year, the Australian stockmarket falls at least 10% at some point in time - even in calendar years when the Australian market ends the year with a positive return:

Markets are inherently volatile. These are the returns of the US S&P500 Index so far in 2022[ii]:

January -5.2%
February -3.0%
March +3.7%
April -8.7%
May +0.2%
June -8.3%
July +9.2%
August +4.1%

Over the past 96 years, on average, the stock market is down 5% or worse in a month about once a year, meaning 2022 has been a volatile year so far. But 2022’s volatility is modest when you consider what happened in 1932:

January -2.7%
February +5.7%
March -11.6%
April -20.0%
May -22.0%
June -0.2%
July +38.2%
August +38.7%
September -3.5%
October -13.5%
November -4.2%
December +5.7%

Can you imagine living through that kind of volatility today?

Going back to 1926, the S&P 500 is positive in roughly 63% of all months, meaning it’s negative in 37% of monthly returns.

That’s not a bad winning percentage but still leaves plenty of room for losses. It also may encourage some investors to time markets.

Trying to time markets almost always leaves investors worse off. That is because they have to get two difficult decisions right – when to sell and when to buy back in. It is the same principle with super fund members: When to switch out of a particular investment option and when to move back.

Outguessing markets is more difficult than many investors might think. While favourable timing is theoretically possible, there isn’t much evidence that it can be done reliably, even by professional investors.

Tactical asset allocation, or TAA, is an investment strategy that varies the proportion of assets held depending on predictions based on either technical and/or fundamental analysis concerning returns in the short run. In other words, it’s a fancy term for market timing.

Academics recently evaluated the performance of tactical allocation funds in the U.S over the period January 1994 to October 2016[iii]. As of October 2016, a total of 111 tactical allocation funds with $65 billion in assets were attempting to deliver better absolute or risk-adjusted returns vs the market by deftly switching exposure among asset classes.

Following is a summary of their findings:

Tactical allocation funds had an average expense ratio of 1.39% (they are very expensive) and an average turnover of 289% (trading costs are high and tax efficiency is low).
TAA funds underperformed all benchmark indexes and had lower absolute and risk-adjusted performance. The average TAA fund had cumulative returns of 215% versus 486% for a market portfolio. They even underperformed the low-risk Barclays Aggregate Bond Index, which returned 242%.
Their annual alpha (market outperformance) of -1.92% was significantly higher than their average expense ratio of 1.39%.

Their findings are consistent with those of Joseph McCarthy and Edward Tower, authors of the study Static Indexing Beats Tactical Asset Allocation, published in The Journal of Index Investing Spring/Summer 2021. They found that tactical allocation funds had higher expense ratios, higher turnover than static index funds and produced lower returns while experiencing higher return fluctuations than their corresponding benchmark index funds.

The bottom line is that tactical allocation funds are just another in a long list of funds that Wall Street created to be sold but should never be bought. Sticking to a long-term strategic allocation is the prudent course.

Author: Rick Walker

[i] ‘Stay the course’: Cash option proves costly for super switchers. John Collett. 31 May 2022 SMH

[ii] https://awealthofcommonsense.com/2022/08/the-price-of-admission/

[iii] https://www.evidenceinvestor.com/tactical-allocation-vs-static-indexing-which-one-wins/? - Srinidhi Kanuri, James Malm and D.K. Malhlotra, authors of the study Is Tactical Allocation a Winning Strategy? published in the Fall 2021 issue of The Journal of Index Investing