By David Wismer Investors received a small taste of downside volatility last week, with the major indexes recovering on Friday to see only a small weekly decline. The Dow Jones, the S&P 500, and the NASDAQ Composite posted losses ranging from 0.6% to 1.1%, with the worst market day (down about 1%, attributed to talk of Fed bond purchase tapering) occurring on Wednesday, August 18. However, the Russell 2000 fared significantly worse on the week, losing 2.5%. The CBOE Volatility Index (VIX) did see a brief move above 20, a relative rarity since March of this year. Reflecting the relative market calm seen in the VIX, and numerous all-time highs for the major indexes in 2021, the S&P 500 has spent over a year above its 200-day moving average. Even more impressively, says Barron’s , “The S&P 500 has been more than 8% above its 200-day moving average for 198 days, the longest in 40 years and among the five longest stretches in history.” However, they also note that, “These streaks are usually followed by a couple of months of choppy trading, with a median gain of just 0.3% over the following two months.” With the market entering the typically higher-volatility months of the fall, it would not be surprising to see some disruption of the market’s calm behavior. 2020: An unprecedented year for the markets Hopefully, whatever volatility does come to pass in the upcoming months will be nowhere close to 2020’s action—especially that of the first quarter of 2020. In Q1 2020: - The VIX shot up to the highest level seen since the financial crisis in 2008. - The S&P 500 fell swiftly by 33.9%, in what Yardeni Research notes as the shortest-duration bear market in modern market history (33 days). - The Dow Jones Industrial Average had some of the worst daily drops ever recorded on an absolute or percentage basis, falling 7.8%, 10%, and 12.9% on separate days in March 2020. For the entire year of 2020, there were also some unprecedented market moves. Sam Stovall, chief investment strategist at CFRA Research , pointed out in a year-end recap , “The S&P 500 closed up or down at least 1% in 110 of this year’s 253 trading days, compared to just 38 days in 2019.” Best market days/worst days: Does it really matter? In looking at those heavy down days of 2020, it has to be noted that there were some spectacular up days as well. The S&P 500 was up over 5% on March 17 and 26, and over 9% on March 13 and 24. This is not unusual in periods of market declines. Similar market behavior was seen during the dot-com and financial crisis bear markets. Numerous studies have shown that the worst market days and the best market days tend to cluster together in highly volatile periods. The trick for investors is figuring out if those bear market rally days are simply partial “retracements” of a down period, or the start of a true market recovery. It is also interesting that during periods of lengthy bull markets, the argument for passive investing takes on new resonance—a version of “ recency bias .” One of the most common arguments is that investors should avoid moving capital to the sidelines because in doing so risks missing the best days of the market, and this will cause their returns to underperform. Will Hepburn, vice president of investment research with Shadowridge Asset Management , has annually updated his research on “Best vs. Worst” market days —and what the impact is of missing either of those. He looks at various numbers of days in the following table, comparing annualized returns of different scenarios to that of the S&P 500’s 8.44% annual return since 1990. The two most obvious conclusions from the research study are: 1) if an investor misses the best market days, returns will significantly underperform; 2) if an investor misses the worst market days, returns will significantly outperform. The best case scenario, of course, is missing as many of the worst days as possible, while being in the market for a high percentage of the best days. But what if an investor misses both the best and the worst? Mr. Hepburn’s research over the years has consistently come up with the same conclusion. There will be a small outperformance in returns compared to the S&P 500. Though it appears slight on the surface, with compounding, this can truly make a difference over many years for long-term investors. Why is this? According to Mr. Hepburn, “The reason that missing both the best and worst days increases one’s returns and dramatically reduces volatility is that the worst days in the stock market tend to be much worse than the good days are good. Throw in the math of gains and losses and the case for risk management becomes clearer.