Rightfully so, much is made of market volatility. Seeing the shift in value of hard-earned savings can make anyone feel uncomfortable, but a missing ingredient in the assessment of market volatility is often time. Time, along with other best practices such as diversification and quality, remains one of investors’ greatest and most underappreciated assets. In addition to time, separating the economic juggernaut of capitalism from short-term market concerns is also an important factor in being a successful long-term investor. With data, we’ll attempt to explain how a simple shift in evaluation time horizon can make you a less stressed and more effective market participant.
The value of our most productive assets, such as ownership in a business or a loan to a business, is associated with two primary inputs: the future cash flows that it can deliver and the level of interest rates. Businesses, in delivering cash flows, ride the long-term trend of the economy while interest rates are influenced by Federal Reserve policy and inflation levels. It would stand to reason, therefore, that the variability in the value of a collection of diversified business interests (your stock portfolio) would carry the same amount of volatility as the two primary inputs. Yet that is far from the case. The stock market is far more volatile than either the economy or interest rates. And not by a little.
From 1962 to 2021, the U.S. economy’s average annualized nominal growth rate (real + inflation) was 6% and carried a standard deviation of 3%. During that same period, the ten-year Treasury yield averaged 5.8% and had a standard deviation of roughly 3% as well. Standard deviation is simply a measure of how much annual variance was evidenced relative to the average from the entire data set. Think of a data set with low standard deviation as being a tight set of dots around an average line and a high standard deviation as being a more spread-out set of dots around an average line.
Now, here’s the shocker; over the same sixty-year period, the S&P 500 produced a 10.5% annualized return, but did so with a standard deviation of 17%, almost six times the volatility of its two primary drivers. Why is that and what does it mean? How do we take something that is reasonably steady, such as economic growth and interest rate levels, and turn it into something that requires six times the stomach from a volatility standpoint? It happens, because collectively market participants have different objectives, time horizons and understanding of how businesses are valued, which results in wild, speculative and emotion-filled swings in public business values, despite long-term inputs that would suggest a smoother ride would be more appropriate. This delta is often attributed to “Mr. Market,” a term coined by Ben Graham in 1949 to describe the market’s periodic disconnect from longer-term fundamentals.
So, what can an investor do to not get dragged into the morass? For starters, to paraphrase Warren Buffett, just because somebody is offering you a low price for your business interests, doesn’t mean you have to sell. Secondly, you can use Mr. Market’s mood to your favor and allocate capital accordingly. Be cautious when he is euphoric and lean more towards buying when he is cranky. Lastly, you can shift your evaluation period for stocks from annual measurements to a rolling five-year evaluation period or even longer. During the previously referenced 60 years, the standard deviation of the average five-year annualized return dropped to 7% versus 17% when evaluated annually, while the average annual five-year return remained roughly 10%. By simply shifting your evaluation mindset to five years from one year, you can significantly reduce the emotional distractions and noise caused by Mr. Market and increase your odds of being a successful long-term investor.