“A smooth sea never made a skilled sailor”
A market without volatility would be unnatural, like an ocean without waves. The free market, like the open ocean, is constantly churning. For some investors, market moving waves can be exciting, providing a buying opportunity of mispriced securities. But for most investors who focus on their long-term financial goals, the waves in the market can feel violent and threatening.
The degree of market volatility varies from small ripples, to rolling waves, to a financial crisis-sized tsunami. While all volatility feels uncomfortable in the near-term, the important question for long-term investors is how to respond to it. This paper will put volatility in context relative to historic trends, and then outline five things to keep in mind when the market gets choppy.
Navigating bigger waves:
We are in the later-stages of a long economic expansion. While we expect above-trend growth through the first half of 2019, then moderating to 2% thereafter, it is important to acknowledge that volatility tends to be elevated in the second half of the business cycle. To expand upon our nautical metaphor, we liken the cyclical nature of volatility to the ocean tide. Volatility ebbs with the positive and steadfast economic news that characterises the beginning of the business cycle, and it flows when the market is mired by slowing economic momentum and fears of recession.
Grab an oar – here’s what you’ll need to do:
Actually, less than you’d think. If you’re a long-term investor, then think of yourself as a cruise liner. Your diversified portfolio was built to feel steady in rough seas.
1. Remember that volatility is normal. Even though it makes us feel seasick.
Volatility in the market is normal and feeling uneasy about a lower portfolio value is normal too. Illustrating how often we experience moderate pullbacks is simple enough.
2. Don’t jump ship at the bottom. Markets tend to rebound after bouts of volatility.
Focusing on the long-term trends of the market rather than the short-term gyrations should give investors the confidence to ride the waves of volatility. When examining historic equity market data, we see a trend of rebounds following equity market pullbacks. That means that investors who jump ship after a big wave may have broken the cardinal rule of investing by “selling low.”
3. Expect market moves to be episodic. While big day-to-day market swings can feel violent, the reality is that they are not all that uncommon. 2% daily moves are not all that common.
4. Focus on the destination. Investors with the luxury of a long-time horizon are rewarded with infrequent negative equity returns.
5. Your portfolio was built for this. Just as a cruise ship doesn’t feel every wave tearing past, a diversified portfolio is buffered from market volatility.
We live in a headline-driven world, where media often impacts equity prices in the near term. But your portfolio shouldn’t be a kayak tossed and turned by market churn; it is possible to gain portfolio stability through diversification. While equities tend to perform better with economic growth and moderate levels of inflation, rate-sensitive fixed income is important when economic growth falters.
The combination of various asset classes may improve portfolio returns, but diversification most importantly keeps your portfolio on an even keel. Although it is no guarantee of positive returns, diversification has improved the risk-return profile of the Asset allocation portfolio relative to equities in a historic analysis over the past 20 years. That means your portfolio can cruise past market volatility feeling the fewest waves possible.
The short-term impact of Brexit could be different from the predicted long-term impact. The studies of the economic impact of Brexit attempt to predict how much larger or smaller the UK economy will be in 2030 – that is, once the UK and EU have adjusted to a new relationship with one another. The short-term economic impact could either be significantly more disruptive than the long-term projections suggest or less so, depending on how the negotiations play out. If the UK Parliament supports the agreement reached between the UK government and the EU and if both sides make good progress in putting in place the new systems needed to facilitate the future trading relationship, the short-term impact could be much smaller than the long-term effects predicted. It could – for example – take some time for any differences in UK and EU regulations to materialise and so some time for any costs to become apparent. However, we must watch this space on that.
Investments can down as well as up and past performance is not a guide to the future.