Download Volatility - past, present and future

Rethinking Risk Strategies
Investing your portfolio
Volatility: Applying yesterday’s lessons
to today’s portfolios
In the US system of government, one of the most important concepts is the separation
of powers. The Executive Branch, the Legislative Branch and the Judicial Branch were
intentionally designed to provide us with a system of checks and balances so that one
branch does not hold a disproportionate influence on the future of the country.
The same concept holds true for portfolio construction. To have a true system of
checks and balances in a portfolio, investors should include a variety of asset classes
so that volatility in one asset class doesn’t dominate the outcome of the entire portfolio.
However, many investors have a tendency to avoid whichever asset class is
underperforming at the moment. But your challenge as an investor isn’t to try to
predict or even avoid volatility; that would be an impossible task. Instead, investors
should seek to understand volatility’s impact on the markets over the decades and
to develop a plan of action that’s mindful of the lessons of the past.
In this piece, we will explore:
The past: Understanding volatility
The present: Focusing on what you can control
The future: Being prepared for what’s to come
The past: Understanding volatility
No major asset class — stocks, bonds or commodities — has been free of volatility. Understanding
market volatility is the first step in building a portfolio that can meet an investor’s long-term goals.
Stocks: More volatile than you think
Many investors base their market expectations for the future on their personal experiences in the
past. And for a lot of people, their history of investing began during the bull market of 1982 to
1999. It’s easy to see how that initial experience may have led to an expectation that bull markets
were normal and volatility was an exception — that 18-year period included:
•Two years with negative returns
•Nine years of consecutive positive returns
•Thirteen years of returns of 12% or more
•Ten years of returns of 20% or more
•Five years of returns of 25% or more
However, personal history is not the same as market history. When you dig deeper, it’s easy to see
that the stock market has always been volatile.
Stocks have lost at least 10% 23 times in the last 116 years
Dow Jones Industrial Average returns from 1901–2016
<-50%
-40% t­ o -30%
-29% to -20%
-19% to -10%
2002
1977
1973
1969
1966
1962
2008
1957
1937
1941
1930
1974
1940
1920
1932
1929
1914
1917
1913
1931
1907
1903
1910
1 time
6 times
4 times
12 times
Source: ©2003–2017 Crestmont Research, CrestmontResearch.com
On average, the market has lost at least 10% about one out of every five years. Does this mean
that investors should avoid stocks? No, but they should understand that large losses can happen,
and they should account for this possibility in their financial plans.
2 Volatility: Applying yesterday’s lessons to today’s portfolios
Bonds: More volatile than investors may think
Bonds are the asset class where many investors turn to escape volatility. But while bonds may not
be as volatile as stocks, they are more volatile than many people think.
Bond prices have fallen more than 1%, 230 times in the last 35 years
Price drops since 1981
-1%
-5%
-3%
-7%
-10%
93 times
57 times
40 times
23 times
13 times
4 times
-15%
Source: Barclays. Data as of Dec. 31, 2016. Bonds are measured by 10-year US Treasuries.
The drops experienced by the bond market may be surprising to investors who view bonds as a
non-volatile asset class. Bonds can play an important role in investor portfolios, but it’s important
to have a realistic view of both their benefits and their risks.
Volatility: Applying yesterday’s lessons to today’s portfolios 3
Commodities: Higher risk doesn’t always equal higher returns
Many investors know that commodities have historically been more volatile than stocks. But those
who believe that “more risk equals more return” may be surprised to learn that this is not always
the case.
Oil: More drops than stocks, with lower returns
Oil vs. stocks — since 1983
Drops of at least -10%
Drops of at least -10%
307
64
Annualized returns
+1.76%
STOCKS
Annualized returns
+10.92%
Gold: More drops than stocks, with lower returns
Gold vs. stocks — since 1975
Drops of at least -10%
Drops of at least -10%
118
64
Annualized returns
+4.47%
STOCKS
Annualized returns
+8.65%
Source: Bloomberg L.P. Data as of Dec. 31, 2016. Oil is measured by the spot price for West Texas Intermediate crude.
Gold is represented by spot prices. Stocks are represented by the S&P 500 Index.
Both oil and gold have experienced more sharp price drops than comparable drops in the S&P 500
Index. And yet, stocks returned more overall than oil or gold.
Ultimately, while oil and gold have also experienced some dramatic price increases — the headlinegrabbing returns that fuel the “more risk equals more return” perception — the effects of the multiple
price drops dragged down long-term returns.
So, why would investors consider investing in commodities at all? One reason is that they can
provide diversification benefits. As we’ll see later in this brochure, there are certain times during
the economic cycle when commodities have historically been the highest-performing asset class,
providing meaningful returns when stocks and bonds have faltered.
4 Volatility: Applying yesterday’s lessons to today’s portfolios
All commodities are not created equal
While oil and gold may be the most well-known commodities, they’re certainly not the only ones.
And statistics show that investing in a variety of commodities has historically provided another layer
of diversification to investors.
For example, within the energy asset class, the components — such as crude oil, diesel oil, etc. —
have a high historical correlation of 0.71. This means they have historically moved in tandem with
each other. And the components of precious metals — such as gold and silver — have a 0.73
historical correlation.
All commodities are not created equal
Combining commodities can lower correlation
• Correlation within commodity complexes • Correlation across commodity complexes
Agriculture
Energy
Industrial metals
Precious metals
Across complexes
Average
correlation
1.00
0.75
0.66
0.50
0.73
0.71
0.54
0.25
0.27
Sources: Invesco analysis and DataStream. Time period represented: Sept. 30, 1990 through Dec. 31, 2016. GSCI Commodity
Index. Past performance is not a guarantee of future results. For illustrative purposes only.
But when you compare energy, precious metals, industrial metals and agriculture, you see that they
have a low historical correlation of 0.27. This shows that not all commodity complexes behaved the
same way over time.
Things to consider
1. All asset classes have experienced volatility — stocks, bonds and commodities.
2. Large losses are not uncommon, and investors must plan for them.
3. Higher volatility does not always result in higher returns.
Volatility: Applying yesterday’s lessons to today’s portfolios 5
The present: Focusing on what you can control
As our study of the past has shown, the risk of volatility is ever-present — and it’s beyond your
control. But within your investment plan, there are elements that you can control — at any age —
to help you reach your goals.
Build realistic expectations
If you’re saving for retirement, it’s important for you to understand that the market is going to have
ups and downs.
Returns don’t happen in a smooth, straight line
While the average return for both lines is the same, the experience is much different
• Index average return • Real-world return
1928
1936
1944
1952
1960
1968
1976
1984
1992
2000
2008
2016
$10,000,000
1,000,000
Average return for
both lines is 5.59%
100,000
10,000
1,000
Source Bloomberg L.P. Based on S&P 500 Index daily returns. Data as of Dec. 31, 2016. An investment cannot be made
directly into an index. Past performance is not a guarantee of future results.
From 1928 through 2016, the S&P 500 Index returned an average 5.59% a year. But an average
return year-over-year of 5.59% is quite different from how returns happen in the real world.
Market fluctuations necessitate good communication with your advisor to make sure that your
portfolio continues to align with your goals over time — especially in periods of heightened volatility,
and also when you’re closing in on a major financial event, such as buying a home or sending a child
to college.
6 Volatility: Applying yesterday’s lessons to today’s portfolios
Maximize contributions
It’s a simple fact that we can’t control the market’s returns. But contributing more to your portfolio
could help you reach your goals despite market returns.
Takeaway
Combining high
savings and a
reasonable upside
potential can help build
wealth for investors.
Saving more may help you reach goals despite the market’s returns
Joe’s annual income is $100,000
• Contributions as a % of total portfolio value • Market returns as a % of total portfolio value
Scenario 1:
Joe invests 10% of his income
each year for 10 years. He builds
a fairly aggressive portfolio that
earns 12%.
Scenario 2:
Joe saves 20% of his income
each year for 10 years and
avoids all market risk by putting
it in his piggy bank.
$274,498
$300,000
250,000
200,000
150,000
100,000
50,000
Scenario 3:
Joe invests 20% of his income
each year for 10 years. He builds
a moderate portfolio that earns 6%.
$193,615
48%
$200,000
100%
27%
73%
52%
Source: Invesco. For illustrative purposes only.
By making the decision to save more, Joe gives himself the option to adopt a more conservative
asset allocation and be less dependent on the whims of the market.
Assess progress pre-retirement
The 10-year mark before retirement can be an important psychological hurdle for investors.
It’s a time to assess their progress to date, and to plan their strategy for the home stretch.
Build your contributions
If investors look at their portfolios and realize they are not on a path to reach their goals, they
can be tempted to make riskier investments. Instead, investors should focus on bumping up their
contribution level first. This is the age where many people have paid off their home, and the kids
may be finished with college, so any newly available cash flow can be used for portfolio contributions.
While some investors may doubt the effectiveness of playing “catch-up,” the following chart shows
that it’s never too late to bump up contributions.
Things to consider
1. Be realistic about the volatility your portfolio is likely to experience.
2. Focus on putting away as much as you can.
Volatility: Applying yesterday’s lessons to today’s portfolios 7
Takeaway
The moral of this tale
is to start saving as
early as possible,
and to increase
contributions
whenever possible.
No one can guarantee
what an investor’s end
portfolio balance will
be, but the odds of
reaching financial
goals are better
if you save more
and save earlier.
The tale of four investors
Every year, these hypothetical investors directed 10% of their $100,000 income ($10,000) into
the stock market, represented by the S&P 500 Index. Some started later than others, and some
implemented various catch-up strategies. Their results are below.
12/77
12/80
12/84
12/88
12/92
$8,000,000
7,000,000
6,000,000
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
John invested consistently for 40 years
Emily invested consistently for 30 years
In an ideal world, all investors would save
early and consistently. John invested 10%
a year from 1977 to 2016, and ended up
with a portfolio balance of $6.23 million.
Starting later can have a huge difference
on a portfolio’s ending balance. This investor
started investing 10% in 1987 instead of
1977, and had an end portfolio balance
of just $1.56 million.
Source: Morningstar. Past performance is not a guarantee of future results. Investments cannot be made directly in an index.
Things to consider
1. It’s never too late to start saving for retirement.
2. Use money freed up from paid-off homes and kids’ college to increase contributions.
8 Volatility: Applying yesterday’s lessons to today’s portfolios
12/96
12/00
12/04
12/08
12/12
12/16
$6.23M
$2.30M
$2.29M
$1.56M
William slowly ramped up his contributions
Jane boosted her investments dramatically
William also saved over a 30-year horizon.
For the first decade, he saved 10% a year.
For the next two decades, he ramped up his
savings to 20% and also instituted a 3%
inflation adjustment per year. He ended
up with a portfolio of $2.29 million.
Jane waited until the last decade before
retirement to boost her savings rate. She
saved 10% annually for 20 years, and then
in the last 10 years before retirement,
dramatically increased her portfolio
contributions to 50% of her income. She
ended up with a portfolio of $2.30 million.
Volatility: Applying yesterday’s lessons to today’s portfolios 9
Living off your investments
“It’s important to finish strong.” This is a common mantra in sports, and many investors feel the
same way, assuming that they can make up for early portfolio losses if they have strong years later
on. But once you reach your retirement years, compounding and losses become even more important
as you begin taking money out of your portfolio to fund living expenses. It’s not always possible for a
portfolio to rally from large losses — especially for retirees. This example illustrates that playing
defense may be especially important early in retirement.
Takeaway
If you’re no longer
adding to your
portfolio, and instead
you’re drawing from
it to provide steady
income, talk to your
advisor about steps
you can take to avoid
a hit to principal early
in your retirement.
Sequence of returns matters
Account balance 1990 to 2010. Each hypothetical portfolio below started with a $1 million
beginning balance invested in the S&P 500 Index, and took $50,000 annual withdrawals, increased
by 3% annually.
• This portfolio is based on actual historical returns from 1990 to 2010. The early years were strong, which set up the
portfolio for a higher ending balance, despite the two hits taken in the later years. •T
his portfolio is based on actual historical returns, but they are calculated in reverse order, with 2010 as Year 1 and 1990
as Year 21. Here, the early returns were weak, and the stronger returns in later years couldn’t provide a significant boost
to the ending value.
Years
0
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19 20 21
$4,000,000
3,500,000
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
500,000
0
Source: Lipper. Data as of Dec. 31, 2016. For illustrative purposes only. Past performance is not a guarantee of future results.
Investments cannot be made directly in an index.
Both investors achieved the same annualized return of 9.45%, but they achieved it in reverse order.
As you can see, the actual order of the returns matters greatly to a retiree making withdrawals.
Because the second investor took a significant hit to principal early on, the ability of the portfolio
to generate income over a retirement lifespan was impaired.
Things to consider
1. For retirees, it’s more important to start strong than to finish strong.
2. Consider ways to potentially lessen the risk of a significant hit to principal early in retirement,
perhaps by balancing the growth potential of stocks with other investments such as bonds
or alternatives.
10 Volatility: Applying yesterday’s lessons to today’s portfolios
The future: Being prepared for what’s to come
As we’ve seen, all asset classes go through times of volatility. What matters for long-term investors
is how you combine these asset classes in your portfolio so that you’re prepared for whatever
economic environment may come.
Separation of powers and your portfolio
Some investors think if they choose a wide variety of stocks, they’re diversified. But that’s like saying
the Senate is diversified because all 50 states are represented. That’s true — to a point. But as part
of the Legislative Branch, the Senate plays a particular, well-defined role in our overall system of
government — just as stocks play a particular role in a portfolio.
Broadly speaking, there are three major economic environments that investors may face — deflation,
inflation and low-inflationary growth — and different asset classes have historically led the way during each.
•Bonds have historically outperformed in deflationary environments.
•Commodities have led the way during times of inflation.
•Stocks have been the clear leaders in low-inflationary growth environments.
During different economic environments, different asset classes have outperformed
Portfolio diversification is necessary when pursuing financial goals across market cycles
Time frame
1929–1941
(13 years)
1942–1965
(24 years)
1966–1981
(16 years)
1973–1981
(9 years)
1982–1999
(18 years)
Inflation
Lowinflationary
growth
2000–2015
(16 years)
20162
Deflation-like1
TBD
Corporate
bonds
Stocks
Market environment
Highest return (%)
Deflation
Corporate
bonds
Inflation
Stocks
Inflation
Commodities
Stocks
15.70
7.00
12.81
18.52
7.77
11.96
Long-term
gov’t. bonds
4.55
Inflation
T-bills
Inflation
6.83
9.22
Long-term
gov’t, bonds
7.71
Commodities
3.06
Corporate
bonds
12.17
T-bills
Corporate
bonds
2.45
Stocks
T-bills
Stocks
5.95
8.23
Long-term
gov’t. bonds
12.08
4.06
Corporate
Bonds
6.70
Corporate
bonds
2.89
Stocks
Commodities
Inflation
Inflation
-0.79
Long-term
gov’t. bonds
2.11
5.16
9.00
2.18
2.12
Stocks
T-bills
T-bills
1.70
Corporate
bonds
2.49
T-bills
-2.43
Long-term
gov’t. bonds
2.53
6.23
1.74
Long-term
gov’t. bonds
1.75
Long-term
gov’t. bonds
2.49
Inflation
Commodities
T-Bills
3.29
-1.51
0.20
6.06
0.79
Inflation
Lowest return (%) Lowinflationary
growth
Commodities index was not incepted
11.37
Sources: Ibbotson; Bloomberg L.P., Invesco (commodities). Stocks are represented by the S&P 500 Index; inflation by the Consumer
Price Index; commodities by the S&P GSCI Index; long-term government bonds by the Ibbotson U.S. Long-Term Government Bond
Index; T-bills by the Ibbotson U.S. 30-Day T-Bill Index; and corporate bonds by the Ibbotson U.S. Long-Term Corporate Bond Index. An
investment cannot be made directly in an index. Past performance is not a guarantee of comparable future results.
Things to consider
1. Build an allocation that provides true diversification — a separation of powers in your portfolio.
2. Stay prepared for changing economic environments with a strategic allocation.
3. Pursue tactical opportunities with overweights and underweights — not going all-in or all-out.
Volatility: Applying yesterday’s lessons to today’s portfolios 11
Explore High-Conviction Investing with Invesco
At Invesco, we’re dedicated to delivering an investment experience that helps you get more out of
life. Our comprehensive range of high-conviction investment capabilities is designed to help you build
portfolios in more precise and impactful ways, and not just settle for average. This high-conviction
approach is built on three core tenets:
A pure focus on investing
All we do is investment management. That means we are solely
focused on delivering high-conviction portfolio solutions to meet your
unique needs.
Diversity of thought
Each of our investment teams is empowered to implement its own
trusted investment philosophy and process. Our diverse range of
capabilities allows you to create high-conviction portfolios custom-built
for your needs.
Passion to exceed
We are passionate about going beyond average to uncover highconviction opportunities and provide an exceptional client experience.
1 This period did not represent a true deflationary period because consumer prices did not fall. However, the reductions in credit supply that occurred in the early
and later part of the decade led to economic contractions similar to what would be experienced in a deflationary environment.
2 Data as of Dec. 31, 2016.
About risk
Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds, and can fluctuate significantly
based on weather, political, tax, and other regulatory and market developments.
Past performance cannot guarantee comparable future results. Neither asset allocation nor diversification can guarantee a profit or eliminate
the risk of loss.
Note: Not all products, materials or services available at all firms. Advisors, please contact your home office.
The Dow Jones Industrial Average is a price-weighted index of the 30 largest, most widely held stocks traded on the New York Stock Exchange. The S&P 500 Index
is an unmanaged index considered representative of the US stock market. The CPI is a measure of change in consumer prices as determined by the US Bureau of
Labor Statistics. The S&P GSCI Index is an unmanaged world production-weighted index composed of the principal physical commodities that are the subject of
active, liquid futures markets. The Ibbotson U.S. Long-Term Government Bond Index is an unmanaged index representative of long-term US government bonds.
The Ibbotson U.S. 30-Day T-Bill Index is an unmanaged index representative of 30-day Treasury bills. The Ibbotson U.S. Long-Term Corporate Bond Index is an
unmanaged index representative of long-term US corporate bonds.
All data provided by Invesco unless otherwise noted.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional
before making any investment decisions.
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