Many of us have been taught to avoid volatility at all costs. That's a grave mistake. In fact, avoiding non-fatal stressors over the long run is actually fatal.
Think about it for a second: If you don't exercise strenuously (short-term volatility for your body), you can wilt away. The principle applies across life: The difficult things we face -- and overcome -- make us who we are. The process of "becoming" is unpleasant, but we are better off for it.
When it comes to the stock market, we are setting ourselves up to learn this lesson in more frequent and painful ways.
Let's start by comparing the individual investor who began investing in 1940 with the one who began in 2000. Here's what they could expect over the next 20 years:
- The 1940s investor would experience 4.2 bear markets (defined as a drop of at least 20%)
- The 2000s investor would experience less than half that -- just 2.0 bear markets.
Here's what that looks like with rolling 20-year time frames:
Seems like good news, right? We humans want less volatility. But something unseen happens without volatility: Bad things accumulate.
Bestselling author, former trader, and risk specialist Nassim Taleb (who foresaw both the Great Recession and the severity of the COVID-19 pandemic long before others) puts it this way: "[Organic systems] need some dose of disorder in order to develop. ... Stifling natural fluctuations masks real problems, causing the explosions to be both delayed and more intense when they do take place."
He goes on to explain an interesting phenomenon: When a forest service decides to immediately put out any fire that arises, it seems like a smart move. But over the long run, the accumulation of dry brush on the forest floor only makes a massive forest fire -- the likes of which cannot be contained -- a guaranteed result.
How does this translate in the real world?
- The average drop in stocks for that 1940s investor was 25% per bear market. Difficult to endure, but not debilitating.
- The average drop for the 2000s investor was 53%, or more than double.
Again, here's what that looks like:
Of course, the 2000s group only has two data points: the dot-com/Sept. 11 crash (49% drop in stocks), and the Great Recession (a 57% plunge). Some would say two data points isn't statistically significant.
But that's the whole point: There were only two, and they were -- historically speaking -- massive!
What investors should do now
Believe it or not, we've already pulled ourselves out of the COVID-19-induced bear market. As of April 21, the S&P 500 has risen 22% from late-March lows. While I'm not saying this trend can't continue, I'm also not taking that as a sign that we're out of the woods.
Case in point: From 1929 to 1940, the market was so volatile that we experienced eight different bear markets. But nobody looks at it that way. It was the (singular) Great Depression.
I hope that's not our fate moving forward. But consider that just last summer, markets threw a fit when interest rates were raised to as little as 2.4%. Historically speaking, that's incredibly low. And while there weren't technical signs of inflation, we were experiencing record-low unemployment as well.
I'd argue that combination -- almost-full employment with such low rates -- was equally in service to something else: low volatility in the stock market. We must start to toughen up and gird ourselves for more volatility. What does that look like for individuals?
- Cover your downside: Make sure that you have reasonable insurance, emergency savings, and have paid off high-interest debt before putting a cent in the stock market.
- Live below your means: Nothing provides peace of mind that can help you ignore market fluctuations like living below your means. When you know your level of "enough", you sleep well at night.
- Take the long view: Remember, you're investing for things in the distant future, like a college education or retirement. Such market volatility can be advantageous if you have a little cash ready to deploy.
Most of all, know your goals. If this trend continues, bear markets will be even more rare -- and even more devastating. Again, I hope that's not the case. But once your portfolio is large enough to provide for whatever your goals are, there's no reason to leave so many chips on the table.