foxex: THE TROUBLE WITH EXPECTATIONS

The Market Sum | INVESTOPEDIA

Insight after the bell

By Caleb Silver, Editor in Chief

Tuesday's Headlines

1. The Trouble with Expectations

2. Chart of the Day: 2018: The Year of Volatility

Markets Close

Dow
24,370.24 -0.22%

S&P
2,636.78 -0.04%

Nasdaq
7,031.83 +0.16%

VIX
21.76 -3.89%

INV Anxiety Index
100.32 Neutral

US 10-Yr Yield
2.879 +0.81%

The Trouble with Expectations

Another day, another wild day in the markets that saw a 500 point swing in the DJIA. We should be used to these gyrations by now since they have been the hallmark of an extremely volatile 2018. As we noted earlier, there have already been at least five days of 3 percent or more drawdowns in the S&P 500 this year, the most since 2011.

The fact that the DJIA and S&P 500 are still relatively flat is remarkable, especially after some of the massive selloffs we've experienced this year. But drawdowns are a part of the game, even though most investors under 30 don't have a lot of experience with them.

Still, something rare has happened in 2018. Ben Carlson, portfolio manager for Ritholtz Wealth Management, podcast host, and blogger, points out that the S&P 500 has experienced a double-double-digit drawdown for the first time since 1990. That means the index fell 10 percent, regained those losses, and then fell 10 percent again.

The average intra-year drawdown is 13.3 percent, and more than half of all calendar years drawdowns have been 10 percent or greater.

(Chart courtesy of Ben)

Ben notes that more than half of the past 68 calendar years have experienced a double-digit drawdown at some point, but only 14 percent of those years ended with the S&P 500 lower for the year. "That means more than 60% of the time when stocks fall 10% or more intra-year, they've still finished the year with gains," Ben writes. "13 out of those 36 years the S&P 500 ended up 10 or more percent higher."

Why it Matters:

Seasoned investors have learned to moderate their expectations and build their portfolios to endure all kinds of markets. It takes discipline and a lot of learning to do that well, and even the best of them still get their faces ripped off now and again (a technical expression for suffering massive losses). Still, having unreasonable expectations is the first step in setting yourself up for disappointment — or worse.

Vanguard recently surveyed its customers and found that their expectations were way off from its own market predictions. The average retail investor expects stocks to return more than 10 percent a year on average. Pension funds, which are far more conservative, expect 7.5 percent average annual returns. Vanguard, which manages trillions of dollars, expects a 4.6 percent return for stocks. Given its influence on the market, I'll bet on the massive money manager from Valley Forge, PA.

What's Next:

Expect more volatility through the rest of the year. I'm not just saying that because of everything we have seen thus far. We are seeing it in our own Anxiety Index, which tracks search volume against fear based keywords like 'short selling,' 'correction,' and 'bankruptcy,' among others. It takes a lot to make the Investopedia Anxiety Index move from neutral to high anxiety, but lately the markets and macroeconomic meters of the Index have been screaming like someone ran over their feet with a lawnmower.

When the Anxiety Index perks up, volatility tends to follow. (James addresses the volatility wave in our chart of the day, below). We've tracked reader anxiety over the past several years, and the Index typically moves before the Volatility Index and major market begin to decline. We are not predicting a major market decline, even though many market watchers are. They get paid to do that. We get paid to help you navigate your investing life no matter what's happening.

Selloffs and drawdowns happen, as Ben demonstrated in the chart above. It's how you prepare for them and react to them that matters most. Here are some useful links to help you do that:

Ray Dalio's All Weather Portfolio (Video)

Investing 101 (Tutorial)

What's the Difference between and Stop and Limit Order?

Other Headlines:

How Apple's Decline is Hurting Berkshire Hathaway

It's Buffett's biggest equity position, so... a lot!

6 Challenges Facing Stocks

Just 6? These are the biggest ones.

GE Falls to levels not seen since Financial Crisis (CNBC)

A lot of retirees and blue chip investors never let go. This hurts.

How Morgan Stanley became Uber's IPO bank (Bloomberg)

Great reporting on a complicated tale.

Chart of the Day: 2018: The Year of Volatility

The VIX, or Volatility Index, was created by the Chicago Board Options Exchange (CBOE) in 1993. It's commonly nicknamed the 'Fear Index,' and for good reason. By measuring short-term S&P 500 options prices, the VIX essentially determines how fearful investors may be about market price swings on the horizon. If investors are generally more worried about big price swings, options contracts get more expensive and the VIX rises in tandem. When investors are calmer, the opposite happens — options get cheaper and the VIX declines.

In February of this year, a massive volatility-based event (that some have referred to as Vol-mageddon) crushed many investors and some funds. ETFs/ETNs based on VIX movement, including VXX, UVXY (leveraged VIX), and SVXY (inverse VIX), made huge price moves when market volatility spiked. These volatility vehicles are still traded heavily now, as the VIX itself cannot be directly traded.

The VIX chart above details the monster spike in February. But perhaps more importantly right now, the chart shows persistently high VIX levels in the past two months when compared with historical averages. As shown on the chart, the VIX began its most recent elevation in early October, right about when the S&P 500 began its latest plummet from record highs. Since that time, the VIX has remained heightened above its 200-day moving average, which has steadily fluctuated around the 16 level. In fact, the VIX has used the moving average on two recent occasions to bounce, right when markets seemed to be calming down a bit.

VIX levels typically return rather swiftly back to the mean (down, in this case). But as long as investors fear an extended market correction, or even an impending bear market, the VIX will likely remain uncharacteristically elevated.