consulting group

online report

Volatility and the

Long-Term Investor
summary

Market volatility has long been a

source of anxiety for equity investors. Over the past several years
in particular, significant fluctuations in market value caused
many investors to rethinkand
sometimes entirely restructure
their investment portfolios,
substantially reducing (or even
eliminating) their equity allocations. While past performance is
not indicative of future results, a
brief examination of long-term
trends in investment performance
may help put short-term market
volatility in perspective. Understanding the truth behind some
common misconceptions about
volatility can be an important
step in the prudent management
of your overall portfolio.

understanding the reality behind some common misconceptions

tocks play a major role in most

portfolios, but sudden market
movements can cause doubts about
the wisdom of a long-term commitment to equity investing. It is important, however, to put market volatility
in the proper perspective. Sudden
declines are hardly uncommon in the
stock market, and in fact can be part
of a normal market cycle. The risk
of short-term loss is one that equity
investors simply must be prepared
to accept. While diversification and
prudent portfolio management may
reduce this risk, it cannot be eliminated entirely.
As we know from the past several
years, a serious bout of market volatility can be alarming, particularly
when youre not expecting it. Amid
such uncertainty, it is all the more
important to keep your eyes on the
markets true prize: the potential for
better-than-average long-term performance. Since the mid-1920s, longterm investors in US stocks typically
have been rewarded for the risks they
have takendespite the occasional
bear markets.

Theres no question that staying

invested and doing nothing can be
hard when the value of your equity
portfolio has fallen by 10% or more.
This may seem too risky compared to
supposedly safe investments such
as long-term government bonds or
money market funds. But successful investors avoid the temptation to
adjust their portfolios in response to
every short-term dip in the market.
Investors should also understand
that many widely accepted facts
about market volatility are actually
dead wrong. Heres a look at a few of
these myths and the realities behind
them.

myth: market volatility is

getting worse all the time.
owning stocks today is a lot
more risky than it was 20 or 30
years ago.
reality: Its true that the past

few years saw an upswing in volatility, as measured by daily price

movements. There were 134 days in
2008at the peak of the financial crisis when the S&P 500 Index moved
up or down by 1% or more. Thats up

online report / volatility and the long-term investor

from 29 days in 2006just two years

earlier. However, this cyclicality is
part of a long-term pattern. As the
chart on this page shows, daily volatility has risen and fallen repeatedly
in cycles over the past 30 years.
In any case, sharp daily moves,
while unsettling, dont tell the whole

story. Investment analysts typically

measure volatility by looking at standard deviation: the degree to which
market returns in any given quarter
diverge from their long-term trend.
By this measure, market risk has
not increased appreciably over the
past 40 years. During the ten years

Daily Moves in the S&P 500 Index of More Than 1%

(1980-2010)
150
125
100
30-Year
Average:
65

75
50
25
0
1980

1986

1992

1998

2004

2010

Source: Consulting Group, Polaris

Investors cannot invest directly in an index. Past performance is no guarantee of future
results.

8.4%
5.8%

5%

4.1%
2.7%
1.4%
0.2%

0%
Full Period

Less the 10
Biggest Up
Days

Less the 20
Biggest Up
Days

Less the 30
Biggest Up
Days

Less the 40
Biggest Up
Days

myth: after the kinds of

gains investors saw in the late
1990s or mid-2000s, the law of
averages guarantees the next
decade will be a bad time to
own stocks.
reality: Its true that market re-

turns in the late 1990s and mid-2000s

were high by historical standards,
but there is no law that requires
returns to be below average in the
future because theyve been higher
than average in the past.
Using the S&P 500 Index as a
proxy, investors would have earned
an annualized return of about 9.9%
on large-capitalization stocks from
1926 through 2010and this despite
the market turmoil of the past four
years.2 Whether returns are better
or worse in coming years will depend
on economic factors such as inflation,
interest rates, earnings and global
eventsnot the laws of probability.

myth: when the market

starts to rise, smart investors
can always jump back in and
ride the next leg up. meanwhile, the safest thing to do is
to stay in cash.
reality: Timing the market is

Annualized Performance of the S&P 500 Index

(1980-2010 Net of Dividends)
10%

ending in 2010, which included both

the internet bubble and the Great
Recession, the standard deviation
of returns for large US stocks was
18.7%only slightly higher than the
17.3% seen in the decade ending in
1990 and 17.4% in the decade ending
in 1980.1

Less the 50
Biggest Up
Days

Source: Consulting Group, Polaris

Investors cannot invest directly in an index. The performance of the index reflects no
deductions for fees, expenses or taxes which would lower the performance of managed
assets. Past performance is no guarantee of future results.

something that even many professional investors cannot do consistently. And the costs of being out of
the market for even a short time can
be enormous. As the chart on the
left illustrates, from 1980 to 2010a
period containing more than 7,500
trading daysan investor who missed
the 50 biggest up days would also
have missed approximately 98% of
the increase in stock prices during
that period, converting an 8.4% annualized return into an annualized gain
of only 0.2%.

consulting group | morgan stanley smith barney

online report / volatility and the long-term investor

myth: while stocks have

paid higher returns than bonds
or treasury bills over the
long run, the difference hasnt
been all that great.
reality: Over the past 85 years,
returns on stocks have beaten cash
and bonds not by a narrow margin,
but by huge margins. For an example,
an investor who put $1 in large capitalization US stocks at the beginning
of 1926 could have seen that dollar
grow to almost $3,000 by the end of
2010. By comparison, that same dollar invested in long-term government
debt would have grown to just $92,
while $1 invested in Treasury bills
would have been worth only $20.

myth: buying near the top of

a bull market is an easy way to
lose money over the long run.
reality: Historically, investors
who put money in the stock market

near a short-term peak have done

well over the long runparticularly
when compared to Treasury bills
and other supposedly safe investments. An investor who put $10,000
in large capitalization US stocks at
the month-end following the tops of
the last eight bull markets could have
had a portfolio worth more than $1.7
million by the end of 2010. By comparison, someone who invested the
same amounts in Treasury bills at the
same times would have had slightly
less than $394,000.3

myth: even if long-term

returns are higher for stocks,
they still arent high enough
to justify the risk of shortterm losses.
reality: Its true that stocks have
historically been more volatile than
bonds or Treasury bills but stocks
have also provided greater rewards

than bonds and Treasury bills over

the long term.. Total returns on the
S&P 500 have been positive in 61 of
the past 85 yearsor approximately
72% of the time. There have only
been 11 years in which the market lost
more than 10%, and only six years
when it lost more than 20%.
On the other hand, returns have
been greater than 10% in 49 of the
past 85 years, and greater than 20%
in 32 of those years.

myth: stocks may have

beaten bonds and treasury
bills over the long run, but
thats only because the stock
market has had a few great
years. there have been many
periods of time when stocks
have underperformed bonds
and treasury bills.
reality: In 38 of the past 65

yearsor about 58% of the timethe

Cumulative Return of $1
(1926-2010)
$100,000

$17,016

$10,000

$2,982
$1,000
$100

$92

$10

$20
$12

$1
$0

1926

Small Cap

1932

1938

1944

1950

Large Cap

1956

1962

1968

1974

1980

1986

Long-Term Govt Bonds

1992

1998

2004 2009

T-Bills

Inflation

Source: Consulting Group, Polaris, Morningstar

Investors cannot invest directly in an index. The performance of the index reflects no deductions for fees, expenses or taxes which would
lower the performance of managed assets. Please see the disclosures at the end of this document for a list of indexes associated with the
above asset classes. Past performance is no guarantee of future results.

consulting group | morgan stanley smith barney

online report / volatility and the long-term investor

S&P 500 has produced higher returns

than Treasury bills or long-term
government debt. Over longer periods, the results have been even more
lop-sided: from 1945 through 2010,
stocks outperformed Treasury bills
and long-term government debt in 42
of 61 rolling five-year periodsalmost
69% of the time. Over rolling 10-year
periods, stocks outperformed more
than 80% of the time, and stocks
have outperformed Treasury bills
and long-term government debt in all
but two rolling 20-year periods since
1945.

Distribution of Returns for the S&P 500 Index

(1926-2010)

1 Source: Consulting Group, Polaris.

2 Source: Consulting Group, Polaris.
3 Source: Consulting Group, Polaris.
Bull-market peaks were calculated for the
following months: Feb. 1966, Dec. 1968,
Jan. 1973, Dec. 1980, Oct. 1987, June 1990,
Jan. 2000 and Nov. 2007.

2007
2005
1994
1992
1987
1984
1978
1970
1960
1956
1948
1947

0%
-10%

0%
+10%

+10%
+20%

Up Years: 61 (72%)
Down Years: 24 (28%)

conclusion

1931

2008
1937

2002
1974
1930

2001
1973
1966
1957
1941

-40%
-50%

-30%
-40%

-20%
-30%

-10%
-20%

2009
2003
1999
1998
1996
1983
1982
1976
1967
1963
1961
1951
1943
1942

1997
1995
1991
1989
1985
1980
1975
1955
1950
1945
1938
1936
1927

1958
1935
1928

1954
1933

+20%
+30%

+30%
+40%

+40%
+50%

+50%
+60%

Source: Consulting Group, Polaris

Investors cannot invest directly in an index. The performance of the index reflects no
deductions for fees, expenses or taxes which would lower the performance of managed
assets. Past performance is no guarantee of future results.

Top-Performing Asset Classes

(1945-2010)
50
Number of Periods

Of course, we all know that past

performance is no guarantee of future results. There have been lengthy
periodssuch as the late 1970s
when US stocks delivered relatively
poor risk-adjusted performance.
Investors may be able to improve
long-term results, and reduce volatility, by including fixed income, foreign
equities and other asset classes in a
diversified portfolio.
Still, the moral of the story should
be clear: investors who act in haste
fleeing the stock market when the
going gets roughare likely to repent
at leisure. The real risk investors face
isnt just the possibility of further
market volatility, but also the damage
that could result from making sudden
or rash changes in their long-term
investment strategieschanges they
may regret later.

2000
1990
1981
1977
1969
1962
1953
1946
1940
1939
1934
1932
1929

2010
2006
2004
1993
1988
1986
1979
1972
1971
1968
1965
1964
1959
1952
1949
1944
1926

40

45

42

38

44

30
20

16

10
0

11

13
6

Annual

US Large Cap Stocks

Rolling 5-Year

Rolling 10-Year

Rolling 20-Year

Long-Term Govt Bonds

T-Bills

Source: Consulting Group, Polaris, Morningstar, Dec. 31, 2945 - Dec. 31, 2010
Investors cannot invest directly in an index. Please see the disclosures at the end of this
document for a list of indexes associated with the above asset classes. Past performance is
no guarantee of future results.

consulting group | morgan stanley smith barney

online report / volatility and the long-term investor

The large capitalization stock performance cited in this report is for the S&P
500 Index. The S&P 500 is widely regarded as the best single gauge of the
U.S. equities market, this world-renowned index includes a representative
sample of 500 leading companies in leading industries of the U.S. economy.
Although the S&P 500 focuses on the large-cap segment of the market,
with over 80% coverage of U.S. equities, it is also an ideal proxy for the total
market.
The Treasury bill performance cited in this report is for 90-day Treasury
Bills. Equal dollar amounts of three-month Treasury bills are purchased at
the beginning of each of three consecutive months. As each bill matures, all
proceeds are rolled over or reinvested in a new three-month bill. The income
used to calculate the monthly return is derived by subtracting the original
amount invested from the maturity value. The yield curve average is the basis
for calculating the return on the index. The index is rebalanced monthly by
market capitalization.
Inflation is measured in this report using the Consumer Price Index (CPI).
The Consumer Price Index for all urban consumers is a measure of change in
price of goods and services purchased by all urban consumers. Approximately 400 items make up the basket of goods and services measured. Returns
prior to 1947 are not seasonally adjusted. Returns from 1947 forward are
seasonally adjusted. By using seasonally adjusted data, economic analysts
and the media find it easier to see the underlying trend in short-term price
change. It is often difficult to tell from raw (unadjusted) statistics whether
developments between and 2 months reflect changing economic conditions
or only normal seasonal patterns. Therefore, many economic series, including the CPI, are seasonally adjusted to remove the effect of seasonal influences. Seasonal influences are those that occur at the same time and in
about the same magnitude every year. They include price movements resulting from changing climatic conditions, production cycles, model changeovers
and holidays.
The Long-Term Government Bond performance used is this report sources the Ibbotson Long Term Government Bonds Index. The total returns
from 1977-present are constructed with data from The Wall Street Journal.
The data from 1926-1976 are obtained from the Government Bond File at the
Center for Research in Security Prices (CRSP) at the University of Chicago
Graduate School of Business. To the greatest extent possible, a one bond
portfolio with a term of approximately 20 years and a reasonably current
coupon-whose returns did not reflect potential tax benefits, impaired negotiability, or special redemption or call privileges-was used each year. Where
flower bonds (tenderable to the Treasury at par in payment of estate taxes)
had to be used, the term of the bond was assumed to be a simple average of
the maturity and the first call dates minus the current date. The bond was
held for the calendar year and returns were computed.
The Small Cap performance used in this report sources the Ibbotson
Small Company Stocks Index. The Small Company Stock return series is the
total return achieved by the Dimensional Fund Advisors (DFA) Small Com-

pany 9/10 (for ninth and tenth deciles) Fund. The Fund invests in a broadly
diversified cross section of small companies. Portfolios are fully invested:
Dimensional keeps cash levels below 5%, and generally under 2%. Portfolio
turnover averages 20-25% annually.
Ibbotson index performance is calculated by Consulting Group and Morgan Stanley Smith Barney using data provided by Morningstar. 2011 Morningstar, Inc. All rights reserved. Used with permission. This information
contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be
accurate, complete or timely. Neither Morningstar nor its content providers
are responsible for any damages or losses arising from any use of this information.
The illustrations in this report are hypothetical and do not reflect the
results of any actual investment. The data do not reflect the material differences between stocks, bonds, bills and inflation, such as fees (including sales
and management fees), expenses or tax consequences. Common stocks generally provide an opportunity for more capital appreciation than fixed income
investments but are also subject to greater market fluctuations. Corporate
bonds, US Treasury bills and US government bonds fluctuate in value but,
if held to maturity, offer a fixed rate of return and a fixed principal value.
Government securities are guaranteed as to the timely payment of interest
and provide a guaranteed return of principal. The principal value and interest on treasury securities are guaranteed by the US government if held to
maturity.
Past performance is not a guarantee of future results.
Statements of fact and data in this report have been obtained from, and
are based upon, sources that the Firm believes to be reliable, we do not
guarantee their accuracy, and any such information may be incomplete or
condensed. All opinions included in this report constitute the Firms judgment as of the date of this report and are subject to change without notice.
This report is for informational purposes only and is not intended as an offer
or solicitation with respect to the purchase or sale of any security.
Diversification does not assure a profit or protect against loss.
Investing in the markets entails the risk of market volatility. The value of
all types of investments may increase or decrease over varying time periods.
Small capitalization companies may lack the financial resources, product
diversification and competitive strengths of larger companies. In addition,
the securities of small capitalization companies may not trade as readily as,
and be subject to higher volatility than, those of larger, more established
companies.
With respect to fixed income securities, please note that, in general, as
prevailing interest rates rise, fixed income securities prices will fall.
2011 Morgan Stanley Smith Barney LLC, member SIPC. Consulting
Group is a business of Morgan Stanley Smith Barney LLC.
2011-PS-371 2/11

consulting group | morgan stanley smith barney