The recent rise in market volatility has some investors running for cover. In an effort to outrun the market’s ups and downs, many will take action such as selling stocks and buying something else. But what else is there? The other big asset class is bonds, and they also seem expensive compared with history. Cash yields remain low, at the time of this writing. So what are some action choices for investors who are convinced volatility offers an opportunity? They could:
- Sell their stocks and go to cash to reinvest after the market correction.
- Buy shorter maturity bonds to avoid big losses as interest rates go higher.
- Buy low-volatility or high-dividend stocks which may go down less in a correction.
- Acknowledge they’re not good market timers so adhere to a disciplined approach.
This last choice is where Vanguard Target Retirement Funds may help. But before discussing target-date funds (TDFs), let’s look at the ways investors try to escape turbulence and how their actions can backfire.
Strategy 1: “I’ll sell my stocks and buy them back later after the price drops.”
This is called market-timing, and most investors are terrible at it. Financial professionals aren’t good at it either. A study of products that specialized in market-timing showed that, on average, these funds trailed their benchmark by 3% a year.¹
Strategy 2: “I’ll shorten my bond maturity.”
This is another common approach. If rates rise, shortening bond maturities is a plus. But if rates hold steady or go down—which often happens when the stock market falls—investors lose. Shortening bond maturity also means forfeiting the higher coupon of longer bonds and their stabilizing role on equity assets. The chart shows that when stocks do poorly, the only asset that does well are high quality bonds. But it’s important to consider the right bonds for the portfolio, not just for the yield.
Median return of various asset classes during the worst decile of monthly equity returns 1988—2017
Sources: Vanguard calculations based on data from Thomson Reuters Datastream, Bloomberg Barclays, HFRI, MSCI, FTSE, CRSP, S&P, and Dow Jones.
Notes: U.S. stocks represented by Dow Jones U.S. Total Stock Market Index through April 2005, MSCI US Broad Market Index through June 2013 and CRSP US Total Market Index thereafter; emerging markets stocks are represented by MSCI Emerging Markets Index; REITs by FTSE NAREIT Equity REIT Index; dividend stocks by Dow Jones U.S. Select Dividend Index; commodities by S&P GSCI Commodity Index; high yield bonds by Bloomberg Barclays U.S. Corporate High Yield Bond Index; emerging markets bonds by Bloomberg Barclays EM USD Aggregate Index; investment-grade corporate bonds by Bloomberg Barclays U.S. Corporate Index; U.S. Treasury bonds by Bloomberg Barclays U.S. Treasury Bond Index; Hedge fund index by HFRI fund-weighted total return Index and international bonds by Bloomberg Barclays Global Aggregate ex-USD Bond Index. The Dow Jones U.S. Select Dividend Index starts in January 1992; Bloomberg Barclays EM USD Aggregate Index starts in January 1993; hedge fund data start in 1994 and Bloomberg Barclays Global Aggregate ex USD Bond Index starts in January 1990. All data provided through June 30, 2017.
Strategy 3: “I’ll buy low-volatility and/or high-dividend stocks.”
This may work, although by definition, a “low beta” passive portfolio also has a lower long-term return than the broad market. Another issue is that these strategies have become so popular that the valuations have risen. Many of these stocks are also interest rate-sensitive, so this is not an optimal approach if rising rates are a concern. Finally, following this model means buying a more concentrated position in utilities, old-time manufacturing, and banks. Less diverse portfolios are not typically ideal.
Planning for periods of volatility
This all brings us to the humble view that a special talent for timing markets is rare. And you realize that being wrong can have a pretty stiff opportunity cost. Below we see how missing just the ten best days in the market can turn an investor’s equity return into cash-like return. Missing the best 20 days can yield a negative return. Plus, these “best days” are intertwined with “worst days” which makes timing even tougher (eight of the ten best days were during the Great Recession of 2008 and 2009).
Missing the best performance days
S&P 500 total annual return: 2000—2017
Sources: Reuters, Vanguard calculations.
The usual methods of controlling risk can still work. Diversification across asset classes and geography begets lower volatility than a concentrated portfolio. Keeping costs low always helps, especially in the low-return environment we have today. Finally, portfolio discipline is fundamental to achieving good results in volatile markets. That means not chasing performance winners, not panicking during market corrections, and rebalancing the portfolio regularly to maintain the risk profile designed to meet the investor’s long term goals. And in volatile markets, rebalancing can add significant portfolio value.
Target Retirement Funds can give an effective evaluation of the proper levels of equities and appropriate bonds for each point in an investor’s life. Importantly, these portfolios have built-in discipline—they rebalance automatically, returning the portfolio to the prescribed risk and return levels set prior to the emotionally trying times of a market correction.
Participants invested in a 401(k) should know that their target-date investments are designed to remain “on target” during inevitable times of market volatility. Plan sponsors may want to remind their membership that their assets have the mechanisms that can help their portfolios withstand the challenges of market volatility and stay aligned with the goals they set for achieving investment success.
To learn about Vanguard Target Retirement Funds, contact your Vanguard representative or visit Target Retirement Funds on our website.
¹ Tactical allocation funds (as defined by Morningstar) were used in the analysis; a total of 23 funds with 120 months of data were evaluated, from a time period of January 31, 2007, to December 31, 2016. Sources: Vanguard calculations, using Morningstar, Inc. data.
- All investing is subject to risk, including the possible loss of the money you invest.
- Diversification does not ensure a profit or protect against a loss.
- Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
- Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
- Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a Target Retirement Fund is not guaranteed at any time, including on or after the target date.