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What Makes Markets So Volatile?

Source: Morningstar Direct, S&P 500 Index, 3/30/2020. The S&P 500 is an unmanaged index and cannot be invested in directly.

A defining characteristic of the COVID-19 selloff has been the magnitude and frequency of daily market swings. We expect volatility to remain at heightened levels until 1) new coronavirus cases peak and eventually ebb; 2) a consensus emerges on the economic toll of social containment; and 3) corporate profits are revised downward to provide a realistic earnings path in 2020.

Volatility is back in a big way – In 2019, stocks posted their best year since 2013, with only seven days when the S&P 500 moved by more than 2%. Compare that to Q1 2020, which had 21 days when markets moved by more than 2% and eight days with more than 5% movement. Since 1980, the market moves by 2% an average of 15 days in a single year.

Do computers and algorithms make volatility worse? Algorithmic trading uses computer-programmed instructions to place orders based on price and trade volume. These programs capture profits by quickly trading based on market conditions. While often painted as the scapegoat in turbulent markets, algorithmic trading helps lower transaction costs by increasing the number of willing traders, and thus may not make volatility worse.

What about passive investment strategies? Passive index funds track a market weighted index such as the S&P 500. In contrast, many actively managed funds allow portfolio managers to pick individual securities to attempt to beat a market benchmark. Passive index investors generally enjoy lower expenses and are typically more tax efficient. Active funds make trading decisions based on research and human judgment geared to find opportunities during market selloffs but entail higher fees and are often less tax efficient. Investment vehicles that use passive strategies, such as exchange-traded funds (ETFs), are a growing but small part of stock and bond markets. There is limited evidence ETFs trigger or worsen market downturns.

Action for Investors

As unsettling as daily market swings can be, volatility is part of investing. Ignoring short term daily fluctuations and systematically aligning asset allocation weightings to match risk tolerance through rebalancing can help you maintain the mix of bonds and stocks appropriate for your situation, and help cushion the impact of heightened volatility over the long term, regardless of its source.

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