28 Feb Tech Talk: Volatility – An Investors Survival Guide
Volatility is an inherent feature of financial markets, so it is important to look through the noise. Markets can be subject to periods of event-related volatility, from events such as economic uncertainty, monetary or fiscal policy changes and geopolitical tension, and can cause investor confidence can be significantly undermined. However, it is important not to be put off by volatility, instead, remember that it volatile episodes can be a good opportunity to buy assets cheaply. Here, we provide 10 key messages to help investors steer their portfolios through volatile times.
1. Volatility is a normal part of long-term investing
From time to time, there is inevitably volatility in stock markets as investors react nervously to changes in the economic, political and corporate environment. Above all else, financial markets dislike uncertainty. Yet markets are also prone to over-react to events that cloud the short-term outlook. As an investor, it is important to take a step back at these times and keep an open mindset. Essentially, mindset is key – when we are prepared at the outset for episodes of volatility, we are more likely to react rationally and remain focused on our long-term goals.
“Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.” – Warren Buffet.
2. Over the long term, equity risk is usually rewarded
Equity investors are typically rewarded for the extra risk they face – compared to, for example, sovereign bond investors – with higher average returns over the longer term. It is also important to remember that risk is not the same as volatility. Volatility refers merely to short term fluctuations in an asset’s price. An investment can perform very well over the long term even if it is volatile in the short term. In the long term, stock prices are driven by corporate earnings and have generally outperformed other types of investment in real terms, i.e. after inflation (see Charts 4, 5, 6 and 7).
3. Market corrections can create attractive opportunities
Corrections are a normal feature of stock markets; it is normal to see more than one over the course of a bull market. A stock market correction can be a good time to invest in equities as valuations become more attractive, giving investors the potential to generate above-average returns when the market rebounds. Some of the worst historical short-term stock market losses were followed by rebounds.
4. Avoid stopping and starting investments
Those who remain invested typically benefit from the long-term uptrend in stock markets. When investors try to time the market and stop-and-start their investments, they can run the risk of denting future returns by missing the best recovery days in the market and the most attractive buying opportunities that become available during periods of pessimism. Missing out on just five of the best performance days in the market can have a significant impact on longer-term returns (see Chart 2 and Table 2).
5. The benefits of regular investing stack up
Irrespective of an investor’s time horizon, it makes sense to regularly invest a certain amount of money in a fund, for example, each month or quarter. This approach is known as cost averaging. While it doesn’t promise a profit or protect against a market downturn, it can help lower the average cost of fund purchases. And although regular saving during a falling market may seem counter-intuitive to investors looking to limit their losses, it is precisely at this time when some of the best investments can be made, because asset prices are lower and will benefit from any market rebound. (Investors should always review their portfolio from time to time and adjust it if needed.)
6. Diversification of investments helps to smooth returns
Asset allocation can be difficult to perfect as market cycles can be short and subject to bouts of volatility. During volatile markets, leadership can rotate quickly from one sector or market to another. Investors can spread the risk associated with specific markets or sectors by investing into different investment buckets to reduce the likelihood of concentrated losses. For example, holding a mix of ‘risk’ assets (equities, real estate and credit) and defensive assets (government and investment grade bonds, and cash) in your portfolio can help to smooth returns over time.
Investing in actively managed multi-asset funds can be a useful alternative for some investors as they provide ready-made asset level and geographic portfolio diversification. These funds are typically constructed on the basis of strategic long-term asset returns, with asset weights managed tactically according to expected conditions. Spreading investments over different countries can also help to bring down correlations within a portfolio and reduce the impact of market-specific risk.
7. Invest in quality, dividend-paying stocks for regular income
Sustainable dividends paid by high quality, cash-generative companies can be especially attractive, because the income element tends to be stable even during volatile market periods. High quality, income-paying stocks tend to be leading global brands that can weather the ups and downs of the business cycle thanks to their established market shares, strong pricing power, and resilient earnings streams. These companies typically operate in multiple regions, smoothing out the effects of patchy regional performance. This through-cycle ability to offer attractive total returns makes them a useful component of any portfolio.
8. Reinvest income to increase total returns
Reinvesting dividends can provide a considerable boost to total returns over time, thanks to the power of compound interest. To achieve an attractive total return, investors need to be disciplined and patient, with time in the market perhaps the most critical yet underestimated ingredient in the winning formula. Regular dividend payments also tend to support share price stability and dividend-paying stocks can help protect against the erosive effects of inflation.
9. Don’t be swayed by sweeping sentiment
The popularity of investment themes ebbs and flows – for instance, technology has come full circle after a late 90s boom and 2000s bust. Overall sentiment to emerging markets tends to wax and wane with the commodity cycle and as economic growth slows in key economies like China. As country and sector specific risks become more prominent, investors need to take a discriminating view, since a top-down approach to emerging markets is no longer appropriate.
But there are still great opportunities for investors at the stock level, as innovative emerging companies can take advantage of supportive secular drivers like population growth and expanding middle class demand for healthcare, technology and consumer goods and services. The key point is not to allow the euphoria or undue pessimism of the market to cloud your judgement.
10. Active investment can be a very successful strategy
When volatility increases, the flexibility of active investing can be especially rewarding compared to the rigid allocations of passive investments. In particular, volatility can introduce opportunities for bottom-up stock-pickers, especially during times of market dislocation. At FinPeak, we believe strongly in a core-satellite approach to investing which combines both index tracking (the core) and active management strategies (the satellite) in order to capture outperformance.
Looking through volatility
Historical data can provide useful context that helps investors to both look through volatility and take an unemotional, long-term approach to their investments.
These charts and tables provide compelling evidence for a long-term approach, showing, for example, why an approach of stopping and starting investments over time can run the risk of missing out on some of the best periods of returns.
Table 1. Strongest quarters generally outnumber the weakest ones
Source: Refinitiv, February 2020. All calculations use local currency total returns, except for the Nikkei 225, for which the calculations are based on the price index.
Time in the market beats timing the market. Inertia can be a positive force once the decision to invest has been made: missing the best days in the market can have a significant impact on your overall investment return.
Source: Refinitiv, Fidelity International, February 2020. S&P 500 total return data from 31/12/1992 – 31/12/2019.
Over the long term, equity risk is rewarded:
What the experts say:
These quotes from some of the most successful money managers illustrate how investing in stock markets can be a challenging yet rewarding venture requiring strong research skills, a rational, dispassionate mind-set, a long-term horizon, and patience.
If you would like to know more, talk to Michael Sik at FinPeak Advisers on 0404 446 766 or 02 8003 6865.
This article was produced with reference to Fidelity and may not be the expressed views of FinPeak Advisers, (click here to view the full article).
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