INVESTING & VOLATILITY
Markets have been relatively calm. No great movements over the last few years up or down. Is this going to be the new normal? We don’t think so and neither should you.
Just as many people start to think markets only move in one direction (up), the pendulum will swing the other way. Anxiety is a completely natural response to market volatility. Acting on those emotions, though, can end up doing us more harm than good.
There are a number of tidy-sounding theories about why markets become more volatile. Among the issues frequently splashed across newspaper front pages: global growth fears, volatile energy prices, geopolitical risk, and the prospect of rising interest rates.
In many cases, these issues are not new. The US Federal Reserve gave notice it was contemplating its exit from quantitative easing (an unconventional monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective). Much of Europe has been struggling with sluggish growth or recession for years, and there are always geopolitical tensions somewhere.
In some ways, any increase in volatility could be just as much a reflection of the fact that volatility has been very low for some time. Markets do not go up all the time. If they did, there would be no market “risk” to compensate investors with higher returns.
Here are six simple truths to help you live more comfortably with volatility:
1. Don’t make presumptions. Remember that markets are unpredictable and rarely react the way the experts predict they will. When central banks relaxed monetary policy during the 2008-09 crisis, many analysts warned of an inflation breakout. If anything, the reverse has been the case with central banks fretting about deflation.
2. Someone is buying. Quitting the equity market when prices are falling is like running away from a sale. While prices are discounted, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks,” remember someone else is buying them. Those “buyers” are usually the long-term investors.
3. Market timing is hard. Recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was at its lowest—the S&P 500 rallied and put in seven consecutive months of gains totaling almost 80%. This is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.
The chart below demonstrates how missing only a few days of strong returns can drastically impact long-term investment performance.
4. Never forget the power of diversification. When equity markets have a rough period, highly rated government bonds typically flourish. This helps limit the damage to balanced fund investors. Diversification spreads risk and can lessen the bumps in the road.
5. Nothing lasts forever. Just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As in life, moderation is a good policy.
6. Discipline is rewarded. Market volatility is worrisome, no doubt. But through discipline, diversification, and understanding how markets really work, the ride can be made more bearable. At some point, value always re-emerges, risk appetites reawaken, and for those who acknowledged their emotions without acting on them, relief replaces anxiety.
FOCUS ON WHAT YOU CAN CONTROL
Research has proven no one can reliably forecast the market’s direction or predict which stock or investment manager will outperform, so it’s vital to follow your plan and focus on actions that add value.
Create an investment plan to fit to your needs and risk tolerance. Humans are not wired for disciplined long-term investing, so it’s critical to have an honest assessment of your personal risk tolerance and the discipline to stick to a well thought out plan. When people follow their natural instincts, they tend to apply faulty reasoning to investing.
Structure a portfolio around the dimensions of returns. Decades of financial research have identified dimensions of higher expected returns in the global capital markets. Portfolios can be structured around these dimensions, which are sensible, backed by data, and cost-effective to capture in diversified portfolios.
Diversify broadly. You never know which markets, or individual stocks, will outperform from year to year. By holding a globally diversified portfolio, investors are positioned to capture returns wherever they occur. Diversification improves the odds of holding the best performers.
Reduce unnecessary expenses and turnover. Invest in funds that have low expense ratios, minimize turnover whenever possible, and seek to add value through portfolio design and implementation.
Minimize taxes. It’s not about what you earn; it’s about what you keep! Taxes are an important consideration when constructing an investment portfolio.
Willow Creek helps you build long-term portfolio wealth steadily without taking unnecessary risks, while applying an intelligent, consistent approach to asset management.