After years of low volatility, markets are swinging. Ben Hurley investigates what you should do.
The past several years have seen some of the smoothest financial markets in recent history. Last year the primary index of US stocks, the S&P 500, returned 19.42 per cent, and came within 3 per cent of an all-time high for 202 straight days – an incredibly long stretch of abnormally low volatility.
But financial markets are becoming more volatile. In February this year the same index saw both its worst week in two years, and its best weekly performance since 2013. Across several weeks in October stocks were abruptly slammed, with the S&P 500 at one point losing all its gains for the year.
Click here to read more on the volatility that hit markets globally in October.
Responding to this surge in volatility, rising numbers of experts are raising red flags over the current growth phase of the economy, which by some measures is the third-longest on record, pointing to the inevitability of a downturn.
ANZ Wealth chief investment officer Mark Rider says investors may need to get used to these bigger swings. Financial markets are nearing the end of an extraordinarily low period of volatility and moving into one where markets fluctuate more normally.
“The last few years have been unusually calm,” Rider says. “As we approach the end of the investment cycle and as uncertainty increases, we will see volatility pick up naturally.”
But this doesn’t have to be a bad thing. When markets swing there are those who lose money but others end up better off. Overpriced stocks become good buys, and investors in a position to snap them up will reap the gains in the next cycle.
They also deliver a dose of cold, hard reality into markets, bringing share prices back in line with their fundamental value and investors who have become complacent are brought back down to earth.
“A bit of volatility can help keep a healthy degree of caution in markets,” Rider says. “There are two sides to it. We would all like a little less volatility but it’s not always bad, and it’s natural.”
What volatile times do make clear is the need for a plan for your investments, whether they’re in superannuation or some other vehicle. For investors who don’t have the confidence to devise a plan themselves, a financial adviser will consider all their important factors:
- how much risk an investors should take on
- how long they have to invest
- the long term goal, while understanding where markets are now at.
Human psychology drives volatility
The first way investors often hear about market slumps – or ‘corrections’ – is from glaring media headlines about investors panicking and millions or billions of dollars being wiped from the sharemarket.
In reality, it is not uncommon for sharemarkets to rise or fall by 2 per cent or 3 per cent over the course of a day, a week or a month.
“Corrections are very normal and generally you will get a 10 per cent drawdown, a fall in the market from its recent peak,” Rider says. “It’s unusual if you don’t get one of those every few years.”
The driver behind this volatility is human psychology. Uncertainty plays on the irrational parts of human nature, and some investors panic. But most of the time, the dust clears and life returns to normal. Only a minority of these corrections result in a prolonged bear market (where prices fall amid widespread pessimism), and when they do there are deeper economic factors at play.
“What turns a correction into a bear market? Generally speaking it tends to be that the economy weakens significantly,” Rider says.
“Interest rates are going up and normally it’s that the economic cycle is ending and [companies'] profits are disappearing. When profits are declining, share prices tend to go with it.”
Responding to bad news
So how should ordinary investors respond to a sudden bout of volatility?
Jonathan Baird, a client service and marketing executive with Western Asset Management, says it is critical to establish whether the “facts” of the investment market have changed.
If economic fundamentals are the same and you have a sound investment strategy in place, the best option may well be to just wait it out rather than run with the herd.
“When people are unsure, their first reaction is to make a decision based on lack of information, and that’s generally to sell,” Baird adds.
This is often a grave mistake. While the value of investments may be impacted by a market slump, the losses are often temporary – unless investors panic and sell before their shares recover, crystallising the losses.
Having a trusted adviser can be crucial at these times, as they watch markets rise and fall every day and are more likely to come up with a sanguine response.
Rockstar investor Warren Buffett has demonstrated the temerity sometimes required to hold the course on a strategy when markets fall. One of his famous quotes is “our favorite holding period is forever”.
His investment philosophy made him one of the most successful investors in the world. He believes investors need to “disregard mob fears”, “focus on a few simple fundamentals” and be willing to “look unimaginative for a sustained period”, as he wrote in a letter to shareholders of his company Berkshire Hathaway.
Hold tight to an investments strategy
But while good investments do usually rise in the long term, those shooting for sky-high gains in a late peak economic cycle might want to look to the late 1990s and early 2000s for lessons, Rider says. After the dot-com boom derailed, some investors had to wait a decade for their investments to recover. For someone about to retire, that could be catastrophic.
Timing markets is almost impossible, but it is important to have an idea what stage of the investment cycle financial markets are in. This allows investors to tune their portfolios accordingly, Rider says.
“There are limits to how well you can time the market, but investing at the peak of the market is probably a good way to ensure your returns are inferior,” Rider says.
Sometimes this can mean not being too greedy at the top of the market. When markets are rising aggressively it may be a hard decision for investors to realise those gains and re-risk their positions. But strategic goals should trump rash decisions based on short-term gain.
If an investor misses out on some of the froth but their portfolio ultimately holds steady while others fall, that’s also beating the market. And this investor will be in a good position to buy back in at good prices while others are licking their wounds.
Says Baird: “When the facts change its important to be fluid and adaptable to market environments. But it’s also important to be calm in the face of volatility when the facts haven’t changed, and hold the course of a well thought out approach.”