October is here and for stock investors there is something about the month that can bring on feelings of anxiety and downright fear. Why? Because October has been historically associated with above average market volatility. Three major market crashes occurred in October — the 1929 and 1987 crashes and the beginning of the 2008 financial crisis. Market volatility in October is about 32 percent above the annual average of 19 percent.
So why does this “October effect” occur, particularly the higher volatility? I believe the phenomenon is primarily a technical one, not a fundamental one, and is caused by heavier institutional trading, call it the “recalibration theory.”
It goes something like this: investors — particularly institutional money managers — are now in the last quarter of the year and, in seeking to achieve the best performance for the full year, are making final assessments on the outlook for earnings, the economy, monetary policy, etc. and make material changes (i.e. “recalibrating”) their portfolio holdings to achieve the best performance. This results in heavier buy/sell volumes which I believe can lead to heightened volatility and noise in the market.
Should one worry about the “October phenomenon”? What about market volatility in general? The answer to that depends on one’s risk tolerance and financial goals.
It is important to remember that volatility, and the willingness to accept it, is an essential component to achieve higher returns. Why? Because higher return investments, such as stocks, are inherently more volatile than say, bonds or bank CDs. The long-term compound annual return for large cap stocks of about 10 percent is over two times that of bonds. Over time, it has been shown that one gets “paid” in the form of higher returns for the willingness to take on and stomach higher portfolio volatility. If one wants to feel or needs to be more secure owning bank CDs, one has to expect a much lower rate of return.
While we cannot completely eliminate portfolio volatility, there are ways in which we as financial planners can manage and reduce it. This is done largely through diversifying client assets across multiple asset classes such as U.S. stocks, international stocks, bonds, REITs and natural resources. This type of allocation helps us to target not only appropriate expected returns but also higher risk-adjusted return, which to me is the most important measure of return in wealth management.
So, we should not be overly concerned about the “October” effect and remember that it can be managed through proactive allocation and remaining disciplined to an investment and financial plan that aims to provide the optimal combination of return goals and risk management.
Bob Toomey, CFA/CFP, is vice president of research at S.R. Schill & Associates on Mercer Island.