Addressing the high levels of volatility across equity markets
The renewed volatility in global financial markets has revived memories for many investors of the alarming events of 2008 and raised questions about what is the best course of action during times of such upheaval.
While we do not intend to downplay the distress some people may be feeling, the points below may offer a valuable perspective at a time when strong emotions can lead people to make decisions damaging to their long-term welfare.
There are a few points to consider:
1. While periods of volatility suggest continued volatility in the future, there is no indication that volatility in itself is a reliable predictor of future returns.
2. We continue to believe that the best approach from an investment perspective is to be broadly diversified and maintain confidence in the markets’ capacity for pricing risk.
3. We could speculate on where ‘the markets’ go from here, but this is what everyone else is doing. We have no information that is not already out in the market. So in essence, the news is already in the price.
4. The best guidance we can provide at this stage is to maintain a focus on things within your control, like appropriate asset allocation and investment time horizon. Dealing with downside risk comes at a cost, as someone must be willing to sell the protection the portfolio is seeking to buy. These costs increase dramatically in times of distressed markets.
5. History indicates that the equity market, particularly value and small caps tend to underperform at times like these. However there is little evidence that one can time these premiums with any consistency or reliability. News moves quickly and unpredictably – that is the nature of news – so repositioning a strategy in response to past events already in the price is likely to be counterproductive.
6. There is also evidence to suggest that trying to anticipate news before it occurs, is usually counterproductive. What we have observed is that broadly diversified portfolios are performing as we would expect them to at a time of strong risk aversion.
7. Do we expect this volatility to continue? In short, YES in the near term. However, the important point is that there is no evidence that volatility in itself is a reliable predictor of future returns. Indeed, returns in the years following periods of extreme negative performance have been positive on average. What’s more, the research shows that realised risk premiums are not reliably negative during recessions and that attempts to time allocations into and out of risk assets are likely to be futile and will only serve to increase transaction costs.
In summary, our investment philosophy has a foundation based upon:
- The Maintenance of highly diversified portfolios that are focused on capturing market premiums which offer higher average expected returns.
- Developing portfolios that are aligned with an individual’s risk tolerance.
- A defined time horizon which accounts for market volatility in the interim.
In our experience, maintaining a disciplined approach especially when markets are volatile, will deliver a better investment outcome when compared to any knee jerk reaction to short term movements.
Lex Goldsmith | Senior Planning Analyst | Principal Edge Financial Services
10th February 2016
