The above graph shows the realized volatility of the S&P 500 Index since 1960. There are a number of observations about the ‘behavior’ of volatility on stock markets that are worth noting. First: spikes in volatility occur from time to time and in a significant number of cases, they can’t be directly related to a bear market or recession. The most recent example was the period from the end of 2015 to the beginning of 2016, in which realized volatility rose to the levels seen today and the MSCI World Index lost 19% (not an official bear market and not followed by a recession). After bottomed in February 2016, the MSCI World Index gained a whopping 54% between then and the end of October last year.
Second, although periods of high market volatility always feel a bit like the world is ending, the sense of despair this time could be heightened by the fact that until recently, market volatility was extremely low. As the red dotted line shows, realized volatility fell to a historical low of just 5.2% at the end of 2017. We have to go back over 50 years – to the beginning of 1966 – to find even lower levels of volatility. Moreover, at 5%, this level of risk is similar to that for investing in government bonds. In 2017, stocks provided above-average returns at well-below-average levels of risk. So 2017 was the outlier, not 2018.
Dealing with spikes in volatility is perhaps the most challenging aspect of investing. Whatever the reason for turbulence, it never feels good. In these periods, it may be worth bearing the history of market behavior in mind, as this tells us that such periods do occur from time to time and are not necessarily followed by bear markets or recessions. Obviously, it isn’t enough to look at the history alone. But, as we have said several times in recent weeks, we believe that the future for stock markets doesn’t really look that gloomy.