April 2007: What is Normal? A Look at Market Volatility

Nature’s Lessons About the Stock Market

Apparently, the one day stock market decline of 3-1/2% on February 27th was a big deal for the media. However, it was "business as usual" to anyone with a decent memory and more than a few years of investment experience. Occasional gyrations in the stock market are not unusual, they are the norm. That’s what markets do.

Our friends at the Leuthold Group (Leuthold Funds of Minneapolis) pointed out that February’s one day drop of 3-1/2% in the U.S. stock market, as measured by the Standard & Poor’s 500 stock index, was the first one day move of 3% or more in nearly four years (last seen on 3/24/2003). Market historians know that a move of this magnitude is hardly unprecedented or abnormal.

What was unusual was going throughout all of 2004, 2005 and 2006 and not experiencing a single one-day move of 3% or more. The absence of volatility was what was unusual. Prior to that long spell of calm, one in 50 trading days in 2003 saw moves of 3% or more. And, in 2002 roughly one in 15 trading days (an average of once every three weeks) saw fluctuations of that magnitude!

Data since 1948 shows that one day stock market movements of 1% or more occur about 16% of the time (an average of about one in six trading days). The last couple of years were below average while 2003 was double the average with nearly one in three trading days posting a move of 1% or more. In the first quarter of this year, seven trading days (one in nine, or 11%) had one day moves of 1% or more. That’s on par with the past two years, but still well below the long term historical average. So, what’s all the excitement about?

"Reducing occasional losses is an important consideration in our investment strategy and the way we construct portfolios."

HOW DID ASSET ALLOCATION ADVISORS DO?

We sidestepped nearly half of the decline on February 27th. Our portfolios declined by only 50-60% as much as the Standard & Poor’s 500 stock market index. Although we accept that occasional declines are part of the long term investment process, no one ever likes to experience declines. That’s why we take great pains to avoid and lessen the impact of such declines. Reducing occasional losses is an important consideration in our investment strategy and the way we construct portfolios.

Obviously, nobody can extrapolate from a one day event and predict how they might fare in the future. It might be worse, or it might be better the next time around. However, simple logic tells us that if we have only 55-65% of our portfolios allocated to stocks, then only 55-65% of our portfolios are affected by stock market movements.

NATURE’S LESSONS ABOUT THE STOCK MARKET

Think of the stock market like you would the weather. It’s always changing. Most days in the San Francisco Bay Area are enjoyable if not downright beautiful. But, from time to time we may briefly experience extremes like a torrential downpour (not this year, unfortunately), a rare heat wave, and even snow! But, overall this is one of the most moderate, beautiful climates in the world. It’s a great place to be (the Bay Area and the stock market!).

The stock market, like the weather, can make you scratch your head sometimes and ask, "Is this the new norm? Is this the new order of things?" While the rare extreme day can be a little uncomfortable and sometimes disconcerting, be it the local weather or the stock market, these occurrences are really quite normal and nothing to worry about.

CLOSING THOUGHT . . .

Our job is not only taking care of your investment capital, but also helping you to have a more comfortable investment journey. Your returns have been very good, but we also hope that you are pleased with the stability of your portfolio and the measures we’ve taken to design an investment strategy that has the potential to achieve both of our objectives --- profits and protection of capital.***

Greg Schultz & Bruce Grenke
© 2007 Asset Allocation Advisors, Inc.