Recent headlines regarding over 1000 point drops in stock markets are upsetting. It can be confusing when you also read that the economy is strong. Why all this volatility?

Some things to consider:

• The Dow Jones Industrial Average hit an all-time high of 26,616 just last month (compare this to where the Dow was 2 years ago – a level of 16,000 in January 2016). A drop of over a 1000 points may be the largest one day point drop, however we should consider the current level that the Dow is at and consider the market movement in percentage terms. A 4% drop is significant but not the largest one day drop, it is not even in the top 20 of historical percentage drops.
• Volatility linked derivatives and automated computer program trading likely increase the size of these types of dramatic movements. Both of these activities lead to considerable trading volume that can amplify market movements.
• Strong U.S. economic numbers and recently announced strong wage growth have led the markets to anticipate an increase in U.S. inflation. This heightens concerns that the Fed could increase interest rates faster than was previously expected. As we are entering the later stages of this business cycle this stokes fears that the growth stimulator of the last decade - low interest rates - will eventually be removed and an economic slowdown could be on the horizon sooner than anticipated.

Things to remember:

• The economy is strong and indicators still lead us to conclude that a 2018 U.S. recession is unlikely.
• U.S. corporate profits are quite healthy and growing. The recently announced U.S. tax cuts have helped increase these estimates further.
• Market valuations have improved. Coming into 2018 the U.S. markets were trading at expensive valuations. This recent pullback coupled with improving earnings expectations have seen valuations improve.
• This recent pull back has erased only a few months of gains. Market corrections of more than 10% happen during bull markets and we haven’t experienced a sizable pullback in over two years.
• We have had a overly long period of low volatility - volatility is a natural element of investing and it will normalize over time.

Why does asset allocation matter?

Asset allocation is often the primary driver of long term portfolio risk and performance. It is important to revisit this after a prolonged out-performance of an asset class. The type of performance we have experienced in equities the past few years has led to some investors questioning why they have anything else in their portfolio. Many investors start to consider speculative investments like marijuana stocks or crypto-currencies, like bitcoin, and pull away from their lower yielding fixed income holdings. When volatility returns, as it always will,  it reminds us of why we should remember our risk tolerance and understand that asset allocation does matter.

Asset Allocation is the process of diversifying your portfolio of investments across different asset classes to achieve your long term investment goals. It is important because it:

• Reduces portfolio volatility – this is the fluctuations in market value that your portfolio experiences over time. The wider the swings in an investment’s price the higher the volatility
• Reduces downside risk – the amount your portfolio declines
• Drives performance

The two tables below illustrate the impact of asset diversification on performance and volatility. Over a 40 year period a balanced portfolio captured 91% of the performance of the aggressive growth portfolio but only experienced 64% of the volatility. It is important to understand that you can have considerably lower risk while still capturing performance. Many of our clients have experienced this first hand.  During the biggest market downturn in our lifetime – the financial crisis in 2008/09 - the stock markets saw drops of 50% but, given our client’s exposure to fixed income and the use of diversification, their portfolios did not see these dramatic swings. Equity investors were unable to completely avoid the downturn but diversified portfolios were able to withstand it with less downside. As portfolio managers, we also had the opportunity to draw on the fixed income and cash holdings to invest back into equities when markets were at or near their lows – helping to capture the impressive performance in equity markets that followed the large losses. Something that 100% equity investors were unable or unwilling to do.

_{^{From New Year 2018 The Global Investment Outlook produced by RBC GAM Investment Strategy Committee.  Reference currency CAD. Past performance does not guarantee future results.}}

Takeaway

It is important to remember that your asset allocation is a reflection of both your risk tolerance and performance expectations. It should not be something that you change based on market conditions. Investors tend to underestimate risk when markets are performing very well (and overestimate when we see market downturns). This type of emotional reaction leads investors to take on more risk near the top of markets, which can lead to larger losses when markets inevitably correct. This holds true when markets reverse – investors struggle to put money to work in markets that have had poor performance.

The current market turbulence can be emotional but our advice is to trust in your asset allocation and  focus on the fundamentals of the economy – which are still quite strong. We recognize we are nearing the end of this business cycle and expect a recession will occur in the next few years but are confident that our disciplined asset allocation and investment strategies will maintain investment portfolios through these markets.