By proceeding, I acknowledge that I have read and understood the Disclaimer and Copyright Statements .

Possibly, one the most egregious acts of deception made by Wall Street is to downplay the impact of market volatility. Wall Street does an exceptional job of “selling” the investing public on the importance of “staying invested” because it serves their best interest. The only way for Wall Street to make big money off of you is for you to be invested in equities.

Unfortunately, the majority of financial planners discount the impact of volatility when they do financial planning for their clients.

So, what’s the big deal? Well, let’s take a simple look at it. Say, you have a $100,000 account and in year one it earns 20%. Then in year two, it loses 20%. Wall Street would tell you that your average return is 0% – which is accurate, however, the “true return” on your account would be -4% for the period or just above -2% annually.

In order to calculated the difference between what Wall Street promotes as the historic returns in the market and what an investor would have truly realized, I calculated returns for the Dow Jones Index (DJI) from 1920 to 2005. (I calculated this figure by taking the index’s price returns [% change in prices] and added the appropriate dividend yield.)

The annual average return of the Dow Jones Index (DJI) was 11.8% while the true internal rate of return or as I like to say the “true return” of the index was only 9.9% - almost a full 2% less. [The performance figures for the DJI are skewed up. Click here for explanation]. So, how big of a difference does 1.9% make? Assuming that you start with $100,000 and invest it over 30 years, the difference between an 11.8% and 9.9% “true return” would be $1,141,607 ($2,839,580 @ 11.8% vs. $1,167,973 @ 9.9%).

At The MAC, our goal is to participate in bull markets but protect our clients from losses in bear markets. Since it’s near impossible to “get out” right at the top of the market, here’s the critical question that I’d like to answer. Is an investor better off missing all of the bear/down markets if it means missing a fraction of the bull/up markets? To determine the answer I calculated the following scenario. Assuming an investment in the DJI missed all the down years, but only participated in 70% of all the up years, it would have realized a 10.25% true return versus 9.88% true return with a buy-and-hold strategy - almost a full 0.50% improvement. I calculated this by simply assuming a 0% return in down years and multiplied the return in up years by a factor of .7.

For this example, I assumed a 0% return in down years, when, in reality, an account invested in cash would have earned a modest return. Assuming a 3% return in cash during down years, the true return on this scenario jumps to 11.10% – a 1.22% improvement! In conclusion, it is definitely prudent to avoid down years assuming that you still are able to participate in the majority of the up years.

If you would like a MS Excel spreadsheet of my work, simply submit a comment to this blog with your e-mail address, I’ll be more than happy to send it to you.

It’s important to point out that the return for the DJI is skewed up due to the nature of the index and something called survivorship bias. The DJI consists of 30 stocks that theoretically represent the makeup of the entire stock market. Of the original 30 stocks in the index, only one company is still included, which is GE. The vast majority of these companies are either out of business or have been acquired or merged with another company. The index has replaced old failing companies, with new successful companies. Just in the last 5 years, the DJI replaced 4 of the 30 companies in its index.

The S&P 500 index, which includes 500 stocks, does a much better job of eliminating any survivorship bias. This is why the DJI is hitting all time highs, while the S&P is still 7% below its all time high. Studies by Ibbotson and Morningstar put the S&P’s performance for the same period around 10.4%. I was not able to easily obtain the dividend history for the S&P 500 so I had to use the DJI instead. Furthermore, the purpose of this section in not to calculate expected market returns but rather to establish the importance of factoring in volatility when doing financial planning. From this exercise, we can assume that if the average return of the S&P 500 is 10.4%, the true return of the index should be in the neighborhood of 8.5%.

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