From time to time, there will inevitably be volatility in stock markets as investors react to changes in economic, political and corporate environments. As an investor, your mind-set is critical. When we are prepared at the outset for episodes of volatility on the investing journey, we are less likely to be surprised when they happen, and more likely to react rationally. By having a mind-set that accepts that volatility is an integral part of investing, investors can prepare themselves to take a dispassionate view and remain focused on their long-term investment goals.
Equity investors are rewarded for the extra risk that they face by potentially achieving higher average returns over the longer term compared with, say, bond investors. It is important to remember that risk is not the same as volatility. Asset prices fluctuate more than their intrinsic value as markets over- or under-shoot, so investors can expect price movements to drive opportunity. In the long term, stock prices are driven by corporate earnings and have generally outperformed other types of investment such as cash and bonds in after allowing for inflation.
Corrections are a normal part of bull markets; it is normal to see more than one over the course of a bull market. A stock-market correction can often be a good time to invest in equities as valuations generally become more attractive, giving you 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 and breaks to new highs.
Investors who remain invested benefit from a long-term upward market trend. When you try to time the market and stop and start your investments, you run the risk of denting future returns by missing the best recovery days. While it’s impossible to predict when the best and worst returns will occur, we know that missing just a few days of positive market gains can significantly reduce the value of your investments.
Put simply, those who try to avoid short-term losses are likely to miss any short-term gains.
For example, the Australian sharemarket dropped 8.3% on 10 October 2008 – the worst day in 15 years. However, the market rose 5.6% the very next day – the second best day in 15 years. There have been similiar periods of volatility throughout the global financial crisis.
How a notional $10,000 investment would have been affected if the best days were missed:
Fully invested in Australian shares - $29,023
Missed the 10 best market days - $18,130
Missed the 30 best market days - $8,972
(Calc: daily returns of the ASX/S&P 200 Accumulation index (Source: Datastream) from 31 Oct 2003 to 04 Aug 2015)
Fully invested in Global shares - $24,062
Missed the 10 best market days - $16,114
Missed the 30 best market days - $9,392
(Calc: daily returns of the MSCI World index in AUD unhedged (Source: Datastream) from 31 Oct 2003 to 04 Aug 2015)
Irrespective of an investor’s time horizon, it makes sense to regularly invest a certain amount of money, for example, each month or quarter. While it doesn’t promise a profit or protect against a market downturn, it does help you avoid investing at a single point in time. 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 generally benefit from a market rebound. (You should always review your portfolio from time to time and amend it if needed.)
Asset allocation can be difficult to perfect as market cycles can be short and subject to bouts of volatility. You can spread the risk associated with specific markets or sectors by investing into different investment asset classes. For example, holding a mix of growth assets (equities, property and corporate bonds) and defensive assets (government bonds and cash) in your portfolio can help to smooth returns over time. Spreading investments over different countries can also help to bring down correlations within a portfolio and reduce the impact of market-specific risk. (Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment. Investments in small and emerging markets can be more volatile than other developed markets.)
Sustainable dividends paid by high-quality, cash-generative companies are attractive during volatile market conditions, because they can offer a regular source of income when interest rates are low and there are few income-paying alternatives available. High-quality, income-paying stocks tend to be leading brands that can perform robustly throughout business cycles thanks to their established market share, strong pricing power and resilient earnings. These companies typically operate in multiple regions, smoothing out the effects of patchy regional performance.
Reinvested dividends can provide a considerable boost to total returns over time, thanks to the power of compound interest. To achieve an attractive total return, you 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 tend to support share price stability and dividend-paying stocks can compensate for the erosive effects of inflation.
The popularity of investment themes ebbs and flows – for instance, technology has come full circle after a late 1990s boom and then a 2000s bust. Sentiment on 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 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.
When volatility sends markets sideways, successful stock-picking and active asset reweighting can be rewarding. Volatility can introduce opportunities for stock-pickers, alternatively shifting some defensive assets (cash reserves) to growth assets (shares) especially during times of market dislocation. Don't forget your risk and return profile though.
Source: DataStream. April 2015