As the 2018 calendar turned to February, the long-anticipated volatility came back with a vengeance, but why were so many, so surprised. As long-term investors, I point out what might be the obvious. The first fissures of this new normal arrived on Friday Feb 2 when the S&P closed down over 2% which seemed to be something most people forgot could happen. Also, as Barron’s recently pointed out, the annualized return for the first 18 trading sessions for 2018 would put us on a pace for an up 158% year; clearly not sustainable by any sane measure. Another important fact however was ignored… The S&P closed exactly 20 years earlier (2/2/98) above 1,000 for the very first time. While Feb 2, 2018 was not a great day, it marked the end of a pretty good 20 years where an investor would have almost tripled their money, and that is what the current take away should be. Risk and reward are inextricably linked, and both must be reconciled to a realistic plan to fund your commitments and goals.
We are now in a period where equity valuations are stretched, and rates will begin a long-anticipated march upwards. The latter concern is in fact what may have spooked the equity markets in the first place. Either way, we are likely to see a greater correlation with equity and fixed-income returns in the medium term and all investors should take that into consideration as they plot a long-term diversification strategy, ideally across uncorrelated risk premia.
Finally, there are no simple answers. Returns in many asset classes may be lower for longer, and if you feel the need to stretch for greater yield, it is very likely you will have amped up (code for leveraged) your risk well beyond your comfort zone. The “can’t miss” trade of shorting volatility via exchange traded notes has become the early 2018 clubhouse leader in how bad this can get, where some investors saw their value move to zero in just a single trading session.
Seek diversification, education and know your risk tolerance. Investing is for the long term.
Bill Kelly has been CEO of the CAIA Association since 2014.