Twenty years from now, some bright young analyst looking at data for the U.S. stock market could be excused for thinking that the S&P 500’s 2.4% total return for October 2014 was no big deal – just one more routine good month in a long bull run. If the analyst is particularly inquisitive, he might wonder why strategies that we typically regard as defensive outperformed – for example, the S&P 500 Dividend Aristocrats (up 4.4%), or the S&P 500 Low Volatility Index (up 4.9%). That’s not what we expect to see in an up month like October – and therein lies our tale.
The key, of course, is to remember that October encompassed two radically different market regimes. Through October 15, the market was in a sharp downdraft, with the S&P 500 falling 5.5%. This was followed by an even sharper recovery in the last half of the month, as the 500 rallied by 8.4%.
We all learn in elementary finance that volatility can reduce returns. If you lose 50% and then make 50%, your compound return is -25%; if you lose 10% and then make 10%, your compound loss is only -1%. Other things equal, lowering volatility can raise returns over time. October is a fine example of that principle in action: