How to Handle Market Volatility and Manage Risk

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This video was recorded on Jan. 25, 2022.

In addition to credit card news, we look at why it will take Johnson & Johnson (JNJ -1.52%) two full years to split its company. Motley Fool analyst Bill Mann also shares his perspective on the market's recent volatility. Plus, Motley Fool host Alison Southwick and Motley Fool personal finance expert Robert Brokamp (and some surprise guests!) discuss ways to manage risk.

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Chris Hill: Today on Motley Fool Money, we're going to take your investing pulse. We want to see how your risk tolerance measures, so roll up your sleeve. This won't hurt a bit. I'm Chris Hill, joined by Motley Fool Senior Analyst, Bill Mann. Thanks for being here.

Bill Mann: How are we doing, Chris?

Chris Hill: We're going to find out how we're doing in just a minute. We've also got some consumer spending data, as well as some healthcare that we're going to get to, but why don't we start with the fact that today is looking a lot like yesterday, and by that, I mean it's the middle of the trading day. You and I are recording this. Jason Moser and I yesterday recorded what apparently was the low for the day yesterday because, at the end of the trading day, it's sunshine and rainbows. Hopefully today ends up the same way.

Bill Mann: It was a "never mind" market. Never mind, as you were.

Chris Hill: You pointed this out earlier today on the morning show that you do for Motley Fool members. Let's just take one stock, Shopify.

Bill Mann: Yeah.

Chris Hill: If you look at Shopify stock price yesterday, it dropped 5.5 percent, and from there, it rose 20 percent. The trading range was 24 percent. That's insane.

Bill Mann: Twenty four percent, and then to put some real brackets around that, that's about $40 billion, a $40 billion presumed change in the value of Shopify from the low yesterday to the high yesterday. I know $40 billion is a big number. But in all ways, it's too big of a number. There is no way that Shopify's actual value changed that much. It's just a matter of sentiment. We always talk about, on the morning show, that the stock price equals how's the company doing times how are people feeling right now. In times of extreme fear, which I think yesterday was, and I think today probably applies as well, the amount of benefit of the doubt that the average investor is going to give any company is negative. It's, at best, zero. These are things that happen from time to time, and they are the wages of owning stocks in the stock market.

Chris Hill: Is it just me, or is the speed getting faster?

Bill Mann: It's just you. [laughs]

Chris Hill: Is it just me?

Bill Mann: It's quite you, Chris. No, it really is. I think it is.

Chris Hill: Look, we've always had volatility at various points in time, but it seems like an additional cost of being a stock investor right now is the speed with which this happens is going to increase. Just get used to a little faster speed.

Bill Mann: I think that that's probably at least partially true. But it bears remember, and if you want just to take your feeling from right now. Depending on how you measure it, we have had somewhere between 10 months and two weeks of pay, and depending if you are a growth stock investor, it's been somewhat longer. But for the S&P 500, it's roughly been two weeks. Just go and look at any chart. For example, take the company NVIDIA, which was down from its high for a 14-year period. Fourteen years, it never made it back to a high that it had had in the early 2000s. I think things are happening faster. There was a trillion dollars added into equities in 2021, more than the 19 previous years combined, and I think that a lot of that money was hot FOMO money. There's not a whole lot we can do about hot FOMO money turning into the process of being either more [inaudible 00:04:25] money or zeroed out. Those are the routes that that money is going to go. Yeah, there is a process involved, and I think it probably does happen faster. It makes me wonder. Back in the day, we thought, with the Internet, we're going to have so much more access to information. I don't know that that information, as it comes to the stock market, has made us, as a collective, any better or smarter at stock-picking.

Chris Hill: Yeah, because if you just happened to blissfully miss the entire trading day yesterday, and you just looked at the headline at the end of the day, you thought this was a nice day. You would have no idea it was a complete roller coaster.

Bill Mann: I got on a plane yesterday at the lows and got back, and it landed right at four o'clock, and the market was flat. I was thinking, why couldn't it have been a longer flight? [laughs]

Chris Hill: We have to get you back on the plane. Let's move on. We talk about allocation all the time, the importance of investors having at least 25 stocks, and I think for a lot of people, myself included, having a stock like Johnson & Johnson, the prototypical, stable, blue-chip business. You look at their fourth-quarter, I get that it was mixed, but they wrapped up the fiscal year with 94 billion in overall sales. It seems like this has been an eventful year they are wrapping up. It seems like they are in a good position for the year ahead, then obviously into 2023 when they expect to complete the splitting off of the consumer products business.

Bill Mann: This joke's probably been made, but they're going to go from being Johnson & Johnson to Johnson and Johnson at some point. The split off is coming from their drug discovery business and their medical devices business. It makes a lot of sense. There are other companies, like Glaxo, that are doing the same thing because you're talking about an industry that is so highly regulated at every step along the way. It is a somewhat more difficult surgery than it would be, say, if a few retail concepts suddenly wanted to go their own way. Some of that time is just going through the legal process of making sure that they don't trip up on any regulatory issue. So I get why that would take as long as it did. This was a great quarter for Johnson & Johnson, and the cynics among us would say, "Yeah, that's because they're selling a vaccine for COVID, and that's been a bull market." That actually was not a huge component of their revenues. It was about five percent. Other areas for Johnson & Johnson were really just incredibly successful. This was the first time that their new CEO, Joaquin Duato was joining in the role of CEO. They had a lot of great things to say for what Johnson & Johnson is doing. Johnson & Johnson, and Johnson & Johnson.

Chris Hill: I'm glad you touched on the how's and why's of the split because when the news first broke mid-November, this was happening, and it made perfect sense at the time. It still makes sense. I did have a little bit of difficulty wrapping my head around the fact that it was going to take, by their own projections, two full years.

Bill Mann: Yeah.

Chris Hill: I just thought, OK, I get this is a $435 billion company. I know it's a big company. That still seems like a long time, but am I correct in interpreting what you said. It's like, look, you always want to be careful when you're doing something like this. You want to be especially careful when you're dealing with something as highly regulated as parts of their healthcare business.

Bill Mann: Rightfully so. I don't know how to say this without sounding negative. I think this is the strength of the system. Think about how touchy the FDA is about swapping out, like, chocolate chips that go into Chips Ahoy. Every tiny bit of this industry is regulated. On the pharmaceuticals, from drug discovery to the building of any types of trials, there isn't a step along the way that is not really heavily controlled by regulators. They're asking permission every single step that they make. It's a tremendously complex legal process.

Chris Hill: Last thing, and then we'll move on. Did the people at Mondelez change the chocolate chips at Chips Ahoy? Did that happen under my nose, and I wasn't paying attention? [laughs]

Bill Mann: I'm sorry that was a little bit of a drive-by mention. No, but what I was saying was that in any situation, even something that seems that innocuous, the FDA is involved. So you can imagine what it's like when you're talking about drug discovery.

Chris Hill: Fair point. American Express (AXP -2.05%) saw record spending on its card in the fourth quarter. I don't want to get too excited about this. I understand why American Express shareholders are excited today. They should be, but I'm not one of their shareholders. I am, however, someone who cares a great deal about consumer spending in this country.

Bill Mann: We did it.

Chris Hill: It's a positive sign. But is this something where it's, like, great, now let's wait and see what we hear out of MasterCard and PayPal and Visa and other people transacting.

Bill Mann: Yeah. I think that that's the case. I would point out that basically this episode so far has been the Berkshire Hathaway portfolio, since both Johnson & Johnson and American Express are very big, Berkshire [inaudible 00:10:54] . Yes, it was a really big, great quarter for Amex. Let's go in the Wayback Machine just a little bit to a few years ago when Amex seemed like they also ran when Costco decided that it was going to end its relationship with Amex. They have done an incredible job coming back to a steady state. They did say in the call that they're hoping to achieve 10 percent earnings per share revenues and mid-teens earnings-per-share growth. This is a compounding company. At an age in which we want the shiny new thing, people don't think American Express, but American Express has been one of the best performing stocks in the market over the last year. They very much are looking at the changes in spending and fintech as being things that American Express, and also Visa, and also MasterCard, these are things that are going to compete them away they are looking to take advantage of.

Chris Hill: Stocks up 40 percent over the past year. I'm glad you mentioned the break with Costco because that really was the start of a rough patch for them due, I would say, in small part anyway, to the color that we got behind the scenes, I think it was a Bloomberg story about [laughs] essentially what went into that breakup. There was no way to read that story and come away with any thought other than, why, American Express really thinks very highly of itself.

Bill Mann: That's right. [laughs] Exactly.

Chris Hill: So the fact that they've been able to turn around that business, it was this great legacy brand. But at some point, the legacy just became another word for old.

Bill Mann: Right.

Chris Hill: Stayed.

Bill Mann: Right. Carte Blanche is a legacy card brand too, and that's not Diners Club. It really did feel like it was going that way. But American Express acted the entire time like they had a rabbit in the hat, and the rabbit in the hat for American Express has been doubling down on marketing, they have a huge marketing spend, and doubling down on shareholder perks and tie-ins. Nearly 50 percent of their revenues go into those two segments alone. They have very much doubled down on American Express being an exclusive high-end product in the financial segment with excellent customer service and excellent perks for their cardholders.

Chris Hill: Glad you mentioned the marketing because seemingly, based on the data, most people in the United States of America watched a lot of playoff football over the weekend, and I noticed a bunch of American Express commercials. I did have the thought, like, is this working for them? They're spending a lot on marketing. I don't have an Amex card. I'm not necessarily looking to get one. I wonder if this is working, and based on the results that we're seeing, yeah, it seems like it's working.

Bill Mann: It seems like it's working, and working to the point where they are a company where everything that they do, they track. They are a data-driven company. The CEO came out and said, yeah, we're going to keep increasing our marketing spend. It is something that has absolutely been working for them.

Chris Hill: Bill Mann, great talk [inaudible 00:14:42] Thanks for being here.

Bill Mann: Thank you, Chris.

Chris Hill: For any investor who needed it, this month has been a good reminder that risk tolerance is a very personal thing. With some thoughts on risks and how to manage it, here is Robert Brokamp and Alison Southwick.

Alison Southwick: When the pantheon of investors speak right up there, it's risk versus reward. Whether you're a trader on Wall Street or an individual investor on Main Street, you probably spend some amount of time thinking about how to minimize your risk while maximizing your possible rewards. Sounds simple enough? For some of us, we don't like the idea of losing money, or maybe we can't afford to lose money. So we like less risky investments. But what if, by being too risk-averse, you actually risk losing purchasing power due to inflation? See, not so simple. Now, this week we're going to explore what risk is and give you the Foolish take for managing it. There are many ways to define risk. Bro will offer four ways to think about it, but interspersed among Bro's ramblings, we'll hear from other Fool investment analysts on how they approach risk. Let's hear from Emily Flippen first.

Emily Flippen: In a classic sense, investment risk is just the risk that any investment has returns other than what you expect.

Alison Southwick: So why are we talking about risk now? It's been the best of times, and it's been the worst of times. Bro?

Robert Brokamp: Indeed, Alison, the last several years have been a great time to be an investor. The S&P 500 earned more than 15 percent a year on average over the past decade, well above its 10 percent long-term average annual returns since the 1920s, and in 2021, the index returned more than 28 percent, which was outstanding. But if you look below the surface, you can see that many stocks are not doing nearly as well. Nowadays, about a fifth of the stocks in the S&P 500 are down 20 percent or more from their all-time highs, and well more than half the stocks in the Nasdaq and the Russell 2000 are down that much. In fact, almost half of the stocks in the Nasdaq are down more than 50 percent from their all-time highs. Our resident Pollyanna and Motley Fool analyst Bill Mann thinks this volatility is actually something you should be a little bit thankful for.

Bill Mann: It doesn't feel like a gift, but it's actually a gift because, right now, you as an investor can determine exactly what your risk profile is. It's impossible to do it when things are going up.

Alison Southwick: Now, while there are many risks investors face, let's talk through four of them today. First up, we have short-term volatility. In 2020, the market dropped more than 30 percent in about a month, and that was an extraordinarily fast drop, and it was followed by an astoundingly fast recovery.

Robert Brokamp: Yeah, this very quick up and down is measured by academics, as well as just folks in the financial industry, by something called standard deviation. The higher the number for a particular investment, the more you can expect that the returns of that investment in any given year will be higher or lower than its historical average. Stocks have a high standard deviation because, even though their long-term average is about 10 percent a year, we could expect anywhere from 40 percent gain or 40 percent loss in any calendar year, and that's the entire stock market. Individual stocks can be up or down even more, sometimes in a single day. Bonds, on the other hand, have a much lower standard deviation because, in any given year, their returns will be within a pretty narrow range. I would say, these days, around a two percent decline and a five percent gain, given today's interest rates. Basically, no huge surprises from bonds, but every year in stocks is full of surprises.

Emily Flippen: Practically speaking, myself and many other investors, actually associate investment risk with the volatility in those returns, so how often those investments rise or fall dramatically over time.

Robert Brokamp: Now, I keep talking in terms of a single year, but when it comes to major declines in the stock market, they actually can stay down for more than a year and take a while to get back to where they were. On average, it takes three years for the stock market to recover from a bear market, and it took around five years after the dotcom crash of the early 2000s. But in investing terms, that's still generally considered short-term or at least short-ish term.

Alison Southwick: Bro, what's the Foolish take on short-term volatility?

Robert Brokamp: It's never fun, but Fools try to ignore it and really accept it as part of investing in stocks. You can't avoid it if you're going to be a part owner of a company, which is what you are when you buy that company stock. It's also why we say that any money you need in the next three or five years should not be in stocks. Put it in cash, [inaudible 00:19:23] , short-term bonds, something safer.

Bill Mann: What I'm ultimately thinking about is, how much emotional pressure do I have to make a bad decision at the wrong period of time?

Alison Southwick: Now, the next risk an investor faces is permanent, or seemingly nearly so, loss, a painful lesson for everyone to learn. Isn't that right, Jason Moser?

Jason Moser: Yeah. I look at risk a couple of ways in regard to the investment itself. It's really the degree to which a given investment will result in a loss, ultimately, permanent loss. We invest to make money.

Alison Southwick: Any individual stock you invest in can go to zero. Enron, WorldCom, all collapsed, and investors lost it all. When you sell a stock, say, Peloton, which is down 80 percent, then that becomes a permanent loss, something I'm trying to avoid. Bro, what's the Foolish take on mitigating the risk of permanent loss?

Robert Brokamp: Alison, when you wade into the world of investing in individual stocks, you have to accept that actually most stocks do not outperform. Many studies have established this, including a recent analysis that was published last year by Morningstar's John Rekenthaler. What he did was he identified the 5,000 largest US stocks as of January 2011 and calculated their returns through December 2020, and this was a time of extraordinarily good performance for American equities. Here's what he found. Forty-two percent of the stocks earned a positive return, the 36 percent lost money, 22 percent of the stocks are no longer publicly traded, and based on his previous research, Rekenthaler estimated that about half of those were likely acquired and probably realized decent returns. But only 13 percent of the stocks outperformed the Morningstar US Stock Market Index. 

The takeaway here is that it's important to be diversified. We, at the Fool, think you should own at least 25 stocks, and I personally like even more, at least until you've established yourself as an exceptional stock-picker, and throw in some index funds for good measure. The Motley Fool provides an allocator tool for our premium members, and it recommends an allocation to total market index funds, in addition to individual stocks. I'm on the Fool's 401K committee, and I can tell you that the total stock market index fund is the biggest holding in the Fool 401K. We all know that it's hard to beat the index, so why not have at least some of your money join it. With an index fund, your chances of permanent loss are very small, as long as you hold on during the tough times, and if the S&P 500 ever goes to zero, which would mean that the largest companies in America have become worthless, we'll all have bigger problems in our portfolios.

Alison Southwick: We've covered the risk of volatility and the market taking a hit. We're talking about the good times, the bad times. But what about the risk number three of, the boring times, extended flat returns. The Dow ended 1964 at 874 points and, 17 years later, ended 1981 at 875 points. Yes, one point higher. The S&P 500 crossed 1500 in 2000, then came the dotcom crash and then the Great Recession. It didn't cross 1500 for good until 13 years later. It took the Nasdaq longer to recover from the first two bear markets of the 2000s. It didn't exceed its dotcom peak until 2016. Most people would think a decade as longer term, yet it's still possible to be underwater after investing in stocks for 10 years or longer. What's the Foolish take on that?

Robert Brokamp: Those extended flat returns were just for US large-cap stocks, but other types of stocks did better. For example, small-cap stocks, real estate investment trusts, even international stocks, depending on which time frame you look at. Even cash outperformed the S&P 500 over the 10-year holding period of 1999-2008, and that wasn't that long ago. This is why asset allocation is important. You don't want your financial future riding on just one stock, one industry, one sector, or one asset class.

Alison Southwick: Now, the last risks we're going to talk about today is the odds that you won't reach your financial goals. You're not just investing to see a bigger number on your brokerage statement, you're investing to pay for something in the future. To most people, that something is retirement, but it could also be your kids' college bills, a vacation fund, world domination. Wait, what, Bro? Whose goal is that? Whatever your goal or if you're already retired, your goal is to make sure your money lasts as long as you do. Bro, how do I make sure my portfolio can pay for my lofty goals of living it up in La Jolla?

Robert Brokamp: It sounds very nice. Alison, unless you've inherited all your wealth, your ability to accomplish those goals really will depend on your ability to earn money, which in turn determines how much you can save, and then the returns you earn on those savings. In other words, it's going to be a mixture of your human capital and your investment capital. Throughout your career, you regularly have to see whether your savings rate and your investment returns are sufficiently teaming up to accomplish your goals. That can be done with a good online calculator, and I emphasize good because some are better than others, or with the help of a competent financial professional just to run the numbers for you. 

There will be times when your returns are so good, you may not have to save as much. But during the times when your portfolio returns are not moving you closer to your goals, you may need to get more from your human capital by saving more. In fact, managing your finances really in a way that empowers you to save a lot of money is one of the most sure-fire investments you can make, and this all brings me to my final point. You can't avoid risks. You can only choose the ones you're willing to take. Doing something to avoid one type of risk, usually, means taking on another so you could avoid the risk of the stock market volatility and the uncertainty by just investing in cash. But then you assume the risk of not being able to meet your financial goals because you're essentially investing in something that yields nothing. So you have to ask yourself, which risks do I most want to avoid, and which am I comfortable taking?

Alison Southwick: Next week we'll be back with more advice and thoughts on risk, including portfolio allocation and mindset. So we'll see you back here next week. In the meantime, let's close with some parting words from Jason Moser.

Jason Moser: Ultimately, I think while I many feel investing is too risky, clearly, the greater risk is not investing at all.

Chris Hill: That's all for today, but coming up tomorrow, how are three healthcare companies investing the money they've earned from sales related to COVID-19, and what will Microsoft have to say about their plans for Activision Blizzard in the metaverse? As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against. So don't buy yourselves stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.