(PUB) Investing 2016

MYTHS Are Stocks More Volatile?

“ The future is more uncertain today .” “ Stocks are more volatile than they were .” THIS IS WHAT SEEMS to pass for com- mon wisdom on Wall Street these days. And it’s repeated on Main Street as well. Almost daily, Dan and I hear from investors who are skittish about invest- ing in the stock market. And these are often the reasons they give. But how do these generally accepted beliefs hold up under examination? Not so well. We can’t quantify uncertainty. But I’d argue that the future is no less clear today than it was a week ago, a year ago or even five years ago. We all suffer from hindsight bias, which is the tendency to see a past event as having been predictable, even though few people at the time actually saw it coming. Looking back, the credit crisis and the bursting of the housing bubble appear to be the obvious outcomes of all the subprime lending that we are now so familiar with. But before those events, the prevailing belief was that home prices don’t fall across the coun- try in unison, and even the likes of then Fed Chair Ben Bernanke thought the effects would be contained. The future is always uncertain, because, well, it hasn’t happened yet! I’m sure at this point you are think- ing, “But wait, the Brexit vote makes things more uncertain, right?” Well, yes and no. On the one hand, before the vote, all the uncertainty was limited to one question (will they, or won’t they?) and had a fixed end date (June 23) when we’d know the answer. Now that the vote is behind us, how- ever, there are a whole host of questions that have replaced one uncertainty with several. For instance, when and how will the U.K. leave the EU, and what does this mean for the long-term viabil- ity of the EU? Will the pound sterling’s devaluation stick? Does London lose its luster as a financial capital?

VIX at Normal Levels

Stocks Are NOT More Volatile Today

50

VIX Avg. Since 1990

10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0%

45

Standard Deviation Long-Term Average

40

35

30

25

20

15

0.0% 5.0%

10

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

2008

2012

2016

7/11

1/12

7/12

1/13

7/13

1/14

7/14

1/15

7/15

1/16

7/16

shows the standard deviation of returns of the S&P 500 index in each calendar year since its 1957 inception. (Standard deviation is a measure of how dispersed returns have been. A low standard devia- tion indicates that returns tended to be close to the average return. A higher standard deviation means returns are more spread out.) Since its inception, the S&P 500 index compounded returns at a 6.8% annual pace—note this is price return only—with a standard deviation of 15.8%. This means that two-thirds of the time, the 12-month price return of the index was between -9.0% and 22.5% (or the annualized return of 6.8% plus or minus the standard deviation of 15.8%). So far in 2016, the standard devia- tion of the S&P 500 has been 15.3%, which is actually a touch lower than average—not exactly an unusual level of volatility. In fact, as we saw with the VIX, for most of the past five years, volatility has been lower than average. Stocks may indeed be too volatile for many investors—that’s why most of us own a mix of stocks, bonds and cash— but to say that stocks are more volatile today is false. And if you’re waiting for market volatility, however normal it is, to disappear or even to fall to some low, low comfort level, well, not only will you be waiting for a very long time, but when that moment of clarity and calm arrives, your best investment opportu- nity may be gone. n

Yes, that sounds like more uncer- tainty. However, you could argue that all those questions were relevant before the vote, and now we at least know the U.K. is leaving. Plus, if the U.K. had voted to stay in the EU, the media’s focus and investors’ questions would’ve circled back to any one of the other concerns out there—negative yields, the U.S. election, terrorism, China, you name it. Rather than getting caught up debat- ing whether the world is more or less uncertain since the Brexit vote, can we agree that uncertainty existed before the vote and persists today? As I said, we can’t quantify uncer- tainty—but volatility is another matter entirely. The VIX, or fear gauge, is a common measure of volatility that you may hear about in the press. The chart above of the VIX over the past five years shows that volatility was high at the start of 2016, but then fell meaningfully until the Brexit vote, which sent volatility rac- ing. (A great example of what can happen when everyone is certain of an outcome that doesn’t play out.) However, the VIX quickly settled down, and for the year has averaged 17.4, which is below its long- term average of 19.8. For much of the past five years, volatility, by this measure, has actually been below average. But the VIX measures expected vola- tility over the coming 30 days. What about the volatility we have actually experienced? The second chart above

The Independent Adviser for Vanguard Investors • August 2016 • 5

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