With everyone talking about the coronavirus, you may wonder what to do, if anything, with your portfolio. There has definitely been a lot of action in financial markets this past week, with no lack of dire predictions and recommendations for your investments. You can expect more of this in the coming weeks. So how should we interpret all the information thrown at us? As we discussed recently, do it like a scientist. While it is impossible to make any reliable prediction about market performance, over 90 years of data on stock market returns can help us put last week’s volatility in the right perspective.
The effects of increased uncertainty
Uncertainty has two effects on the economy and markets. One is that it makes people more cautious in making decisions. This is particularly true when we expect uncertainty to be transitory. For example, in the case of the coronavirus, there is a lot that we don’t know but we expect to know more in the next few months. As a result, we can expect some contraction in general spending, travel, and transportation. All this can cause a temporary strain to the economy. Some companies, including airlines and other companies with global operations, like Apple, have already cited difficulties in their ability to meet revenue guidance due to the effects of the virus.
The second effect of uncertainty is a decrease in investors’ appetite for risky assets. Some of this can be rational. With an increased level of risk, real or perceived, investors require a higher compensation (risk premium) to be enticed to invest in risky stocks. But there is also a psychological aspect. Uncertainty feeds our innate desire to control it. We may think that perhaps now is the time to do something about our portfolio. This desire can lead to suboptimal choices and anxiety, as we have discussed before.
Uncertainty and market returns
Between Feb 21 and Feb 28, the S&P 500 dropped by 11%. That’s about $3 trillion in market capitalization lost. In stock market jargon, a decline of 10% or more is called a correction. If we look at the last 40 years, from 1980 to the end of 2019, there have been 12 corrections, so just about one every 3-4 years. The most recent correction before last week was in the last quarter of 2018. What these events have in common is that no one can predict them. Investors who sold stocks in December 2018 learned this lesson the hard way, as they missed a return of over 30% in 2019. The general lesson from historical data is that if you have been able to hold on to your investments this past week, don’t give up now.
Pandemics and market returns
The chart below shows market returns over six previous viral outbreaks, from the 1957 Asian flu to the 2012 MERS. Starting from the first month of the outbreak, we follow the returns on the S&P 500 index for 24 months. To compare different periods, we start the index at 100 at the beginning of each outbreak.
What to make of the chart? Of the six episodes, three have the above-average returns, including the 1976 swine flu, the 2002 SARS, and the 2009 swine flu. The other three have below-average returns, including the 1957 Asian flu, the 1968 Hong Kong flu, and the 2012 MERS. The average across all episodes is an annualized return of 11%, the same as the average return on the index since 1926.
The chart also shows the level of variability that one can expect from the stock market over a 24-month period. The dotted grey lines illustrate the 10th and the 90th percentiles of returns based on the history of the S&P 500 index since 1926. The solid grey lines represent the 25th and 75th percentiles based on the same data. Besides the first few months in the 2009 swine flu episode, most episodes are within the range of outcomes that we can expect from normal stock market movements.
Lessons for investors
As investors, we should remember that the higher returns of stocks over safer investments like bonds are earned on average and over time precisely for bearing the volatility that comes with stocks. It would be great if we could get the average 11% that the S&P 500 has returned over the last 94 years without bearing the risk, but we can’t. As a long-term investor, you should put last week’s volatility in perspective, as we have tried to do here. Pandemics are just one type of event that contributes to the overall market volatility we have to bear.
While there is nothing we can do to control markets, every period of heightened uncertainty is a good chance to learn more about our psychology and our ability to take risks. Review your investments and make sure the level of risk you are taking is aligned with your goals. This is a great time to create or review your personal investment guidelines.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
