Are You Ready for Some Real Volatility?

Are You Ready for Some Real Volatility?

by Don Chambers, January 2019

Stock markets exhibited substantial volatility in the end of 2018 (September through December). News reports described the declines as being historic by focusing on the large number of points that the Dow Jones fell on a few bad days: the Dow fell 500 points or more nine trading days in the last three months of 2018.

But a drop of 500 points when the Dow is well over 20,000 is not extreme. Market movements need to be evaluated based on percentages. Consider the following hypothetical four-day period for the Dow Jones:

Day
Dow
Point Change
% Return
0
1
2
3
4
 
25,082
24,127
23,551
22,467
17,387
 
-955
-576
-1,084
-5,080
 
-3.8%
-2.4%
-4.6%
-22.6%

The above table hypothesizes drops in the Dow totaling over 7,500 points in four days. Can you imagine if the Dow (which began September 2018 a little under 26,000) experienced the sort of declines shown above? Well, in Oct. 14 – Oct 19 in 1987 the Dow did that, in percentage terms.

The above table was formed by taking the actual Dow in 1987 (which began the month trading around 2,500) and multiplying the level by 10 to put the points in the same scale as 2018. In a four-day period in October 1987 the US stock market dropped a little over 30%! Compare that to late 2018 when the biggest total decline in the Dow took was 19% (from October 3 to December 24) and the two biggest daily declines were only -3.1% and -3.2%.

And October 1987 is not the worst time in history for a stock market. Within a few years of the onset of the Great Depression in the US stocks fell by a total of 90%! The primary index of Japanese equities reached a high in December 1989 at 38,951. Twenty-nine years later, that same index traded at 19,241 during December 2018 – representing a drop of 50% over a 29-year holding period! During the same time period US equity prices have risen ten-fold.

There are three big lessons here. #1. Do not listen to news reports that hype headlines of historic changes based on point changes rather than percentage changes. #2. Diversify: do not invest all your money in a few equities or even in only the equity markets of one country. #3. Be prepared for the possibility that the market will exhibit truly exceptional declines.

Are you prepared for an equity market that declines 30% or more? Do you use margin to finance additional equity purchases – and if so – do you understand the risks you are taking? This is not a warning to get out of equities. Being in broadly diversified equity portfolios is perhaps the best way to accumulate long-term wealth through investing. Just make sure you are emotionally and financially prepared for the inevitable bad times. Hopefully we have seen the worst declines that we are going to see for quite a while to come.

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