If you follow the financial markets closely you will be more than aware that they have been subject this year to considerable volatility. Exactly what does that mean?
A dictionary definition of volatility as it applies in finance is: ‘The degree of variation of a trading price series over time as measured by the standard deviation of logarithmic returns’. I am sure you wanted to know that!
In simpler terms it means the erratic movement up or down of a market index in a relatively short space of time. Where the largest of all markets, the US market is concerned, 2017 was a relatively calm year that produced some very positive returns. 2018 started out the same way but since early February we have seen wild swings in both directions.
What has given rise to the volatility?
Analysts are quick to come up with answers such as concern that interest rates will rise, the potential for trade wars, fear (at one stage) of serious escalation of hostilities with North Korea as well as Syria and even the impact on the US presidency of the alleged ‘hushing up’ of the Stormy Daniels issue.
Less understandable are the rapid recoveries that follow the falls. Maybe it’s a combination of relief the day after a crisis that things are not so bad after all or it could be simply shrewd investors taking advantage of dips in the markets. Or maybe realisation that despite all the ‘noise’, people are still buying hamburgers and cars, still visiting Bali and other destinations and still spending money. When people spend money companies make profits, their share values go up and shareholders receive dividends.
So who gets hurt by volatility?
It could be ‘day traders’ who get their bets wrong as to the direction of the markets. But day traders are effectively speculators who are not interested in fundamentals or the true value of the stocks they are trading. They are seeking quick profits but can also end up with big losses. Or it could be someone who made a large investment the day before a big fall and who might have to wait a while to get back to the starting point. That is, if he or she doesn’t panic and cash everything in at a huge loss.
But losers will also be those ordinary investors who are spooked by negative headlines and decide to cash in their savings to prevent further losses, only to return to the fold again when prices have reached new highs. In other words those who buy high and sell low. Other losers are those who embark on a long term savings plan but become discouraged after a couple of years of losses and decide to bale out, incurring not only losses but also heavy penalty charges for breaking their contract.
Human nature and emotion can be the investor’s worst enemy in the world of investing, where greed and fear can lead to poor decisions.
Can anyone actually benefit from volatility?
Indeed, anyone can. The same people who might abandon savings plans can actually be winners by hanging in and continuing to maintain their contributions during bad times or periods of volatility. By staying the course they are profiting from lower prices and will reap the benefits later on when markets recover. The only proviso of course is that you must hold on until the prices have risen again, even if it means holding on until after a plan matures.
Alternatively, there is always a facility to move into a lower risk fund or cash at an appropriate time short of maturity. Using this technique the gains can be locked in. Where savings plans are concerned volatile funds, such as those invested in emerging markets or commodities, can prove much more profitable than run-of-the-mill defensive funds, even if the overall performance of the funds is identical over the whole period. This is because with a volatile fund you are buying more units or shares when prices are low and fewer when they are high. This is known as cost averaging.
I have known occasions when someone has started a savings plan only to complain after say 12 months that the markets are down by 10% or more and that they chose a terrible time to start the plan. They are surprised when I tell them how fortunate they are as they are now getting a discount on the original unit prices and will reap the benefits later on. – Which they will of course if they don’t panic and abandon ship. Sometimes it’s a hard message to get across as people expect to see gains from day one.
Which is better – regular savings or a lump sum investment?
The situation is not the same however for someone who invested a lump sum and is seeing a 10% loss after one year.
That person has to wait until the markets replenish the loss in order to get back to the starting point. So if you have a lump sum to invest, would it not be wiser to hold it in cash and invest it gradually over 10, 15 or 20 years? Not really, because you are then betting against the likelihood that markets will continue to rise over the long term.
Cash, while a very necessary holding for the short term, is effectively dead money over the longer term. To reduce the impact of any nasty early surprises a common investing technique is to invest in stages into the markets over perhaps one to two years. The cash can be held within a portfolio or platform where switching can be done quickly via a fax or e-mail.
There are plenty of other ways to reduce the impact of volatility. Here are a few of them:
- ‘Long-short’ hedge funds where part of a fund can make money when certain shares or assets fall.
- A well-diversified portfolio which invests in a range of uncorrelated asset classes. For example, gold will often rise sharply when stocks or the US Dollar fall steeply.
- Equity income funds. These focus on companies that pay good and regular dividends. The income helps to offset any fall in the share price.
- Artificial Intelligence. There are now funds using AI that can make quick decisions that are not impacted by human emotions. Work in progress though; the recent fatal accident involving a driverless car in the US springs to mind!
So is volatility a friend or foe?
As you have probably gathered, it can be either but with good financial planning and using some of the described techniques it can be your friend. Then you won’t lose any sleep should you see the stock market index fall by 400 points just before you go to bed!
Colin Bloodworth, Chartered Member of the Chartered Institute for Securities and Investment (UK), has spent over 20 years in Indonesia. He is based in Jakarta but visits Bali regularly. If you have any questions on this article or related topics you can contact him at email@example.com or +62 21 2598 5087.
You can read all past articles of Money Matters at www.BaliAdvertiser.biz
Copyright © 2018 Colin Bloodworth