Volatility - 8 Simple Lessons

Everyone has an opinion about what caused the latest bout of volatility in markets, coming after a long period of relative calm. But the key point for long-term investors is that markets are volatile by nature. Stocks go up and down as information and expectations change. Sometimes, this happens very gradually. Other times it happens more suddenly.

What you can be sure of is that everyone is an expert after the fact.  In January, you might have heard experts saying markets were in party mode, fuelled by a cocktail of accelerating global growth, strong earnings and low inflation. By early February they were saying this was an accident waiting to happen as central banks take away the punchbowl of low interest rates. Well, which is it?

The point is there are any number of reasons markets may rise or fall on a given day. It may be fun to speculate about the drivers, but ultimately it makes little difference if you are a long-term investor. And reacting impulsively to daily market movements is almost always counter-productive.

Increasing market volatility is essentially an expression of uncertainty. Markets move on new information which is incorporated into prices immediately. Those prices reflect the aggregate views of millions of participants, so unless you have information that no-one else is privy to, you are unlikely to get an edge by trying to time your entry and exit points.

What matters for individual investors is whether they are on track to meet their own long-term goals detailed in the plan designed for them. Unless you need the money next week, what happens on any particular day is neither here nor there. And if you do need money next week, it certainly shouldn’t be invested in the stockmarket today!  It is the long-term returns that count.

As to what happens next, no-one knows for sure. That is the nature of risk. In the meantime, you can protect yourself against volatility by diversifying broadly across and within asset classes, while focusing on what you can control – including your own behaviour.

For those still anxious, here are eight simple lessons to help you live with volatility:

1.       Don’t make presumptions.

Remember that markets are unpredictable and do not always react the way the “experts” predict they will. For instance, you’ll see economists on the TV every night talking about what might happen when Europe or Japan eventually raise interest rates. But even if you could pick the turn, you still don’t know how markets will react. It’s pointless to speculate.

2.       Someone is buying.

Quitting the equity market when prices are falling is like running away from a sale. When prices fall to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks”, remember someone is ALWAYS buying them – there must be a buyer for every seller. Those people buying are often the long-term investors.

3.       Market timing is hard.

Recoveries can come just as quickly and just as violently as the prior correction. In 2008, the Australian share market fell by nearly 40%. Some investors capitulated, only to see the market bounce by more than 37% in 2009 and rise in seven of the eight subsequent years. The lesson is that attempts at market timing risk turning paper losses into real ones and paying for the risk without waiting around for the recovery.

The graph below shows calendar year returns for the Australian stockmarket since 2001, as well as the largest intra-year falls that occurred each year.  During this 17 year period, the average intra-year decline was 13%.  About 60% of the years observed had falls of more than 10%, and about 40% had falls of more than 15%.  But despite substantial intra-year falls, calendar year returns were positive in 14 out of the 17 years examined. 

Australian Market Intra-Year Gains and Declines vs. Calendar Year Returns, 2001–2017

Note: In Australian dollars. Australian Market is measured by the S&P/ASX 300 Index (total return). Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. S&P/ASX data reproduced with the permission of S&P Index Services Australia.

This graph illustrates just how common market falls are and how difficult it is to say whether a large intra-year decline will result in negative returns over an entire year.

4.       Stockmarkets are for long-term investors.

Whilst stockmarkets can be volatile over short time frames, over the longer-term the range of outcomes is much narrower and more stable. The graph below shows the trailing 10 year growth in earnings and dividends for the US stockmarket:

Source: ‘Why the Stock Market Falls (Sometimes) Cullen Roche 6 February 2018

Source: ‘Why the Stock Market Falls (Sometimes) Cullen Roche 6 February 2018

The graph shows that stocks have pretty consistently earned 4-10% in earnings and dividends over every 10 year period, with the lowest results coinciding with the GFC and 1970s downturns. That’s a fairly reliable 7% earnings and dividend yield. So, we can guess that stocks will probably go up more often than not because the underlying entities earn cash flows that mathematically lead to higher prices. If you hold stocks for a long time then the odds of benefiting from that positive earnings and dividend trend is pretty high. (We'll discuss  this further in our next article).

5.       Never forget the power of diversification.

When equity markets turn rocky, other assets like highly-rated government bonds can flourish. This limits the damage to balanced investors. So diversification spreads risk and can lessen the bumps in the road.

6.       Markets and economies are different things.

The world economy is forever changing and new forces are replacing old ones. This applies both between and within economies. For instance, falling oil prices can be bad for the energy sector, but good for consumers. New economic forces are emerging as global measures of poverty, education and health improve.

7.       Nothing lasts forever.

Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

8.       Discipline is rewarded.

Market volatility can be worrisome, no doubt. The feelings generated are completely understandable. But through discipline, diversification, keeping focused on progress to your goals and accepting how markets work, the ride can be more bearable. At some point, value re-emerges, risk appetites re-awaken and for those who acknowledged their emotions without acting on them, relief replaces anxiety.  Again, we'll provide more specific details on this in our next article.

With thanks to Jim Parker

Rick Walker