The volatility in stock markets should not have come as a great surprise. The two most important influences on share prices today are the direction of US interest rates and how the trade tensions between America, China and Europe pan out. Both have hit the headlines in recent days and investors are struggling to make sense of mixed messages.
The Federal Reserve’s quarter point cut in interest rates was too much for economists looking at a robust jobs market and buoyant retail sales but too little for a President with an eye on postponing any downturn well beyond next year’s election.
Meanwhile, the announcement of more tariffs, now capturing all of China’s exports to the US, suggests that American shoppers are about to be clobbered by the extension of levies to front line purchases like shoes and electronics. That’s a threat to a US economy that is largely fuelled by consumer confidence.
No surprise that shares bounced around as this news unfolded. The share prices of retailers bore the brunt of the new tariffs in the stock market, with Best Buy, Gap and department store Kohl’s down more than 7% each on the latest Trump tweet bombshell. The oil price suffered its worst one-day decline in three years, nearly 8% lower at one point. Bond yields slumped on the news as prices, which move in the opposite direction, jumped.
Some people will look at those price movements and conclude that today’s volatile markets are a risky place to be. They are wrong to do so. Risk and volatility are two quite different things, although often mixed up in the minds of investors.
Volatility reflects how quickly or how far the price of an investment moves. Risk, on the other hand, is a measure of how likely it is that an investment will deliver a permanent or long-lasting loss of real, inflation-adjusted value.
How correlated the two are is determined by an investor’s time horizon. If you need to access your savings next week, risk and volatility are interchangeable. If you are in this situation, however, you should not be investing in the stock market at all. For a long-term investor, particularly a younger one who is many years or even decades away from needing to use their money, volatility is no risk at all - used wisely, it can even be a significant opportunity.
In recent years, defensive businesses selling items that people buy through thick and thin - detergent and electricity, for example - have been in favour with nervous investors who equate risk and volatility. The share prices of these companies tend to demonstrate low volatility and are, therefore, seen as low risk. In some cases, they may be. But investors are paying a high price for that perceived safety and they may in fact be increasing the riskiness of their investments.
Reducing investment risk is about focusing on the quality of a company and its competitiveness and nothing much to do with how much its share price rises and falls in the short term. Market risk, on the other hand is intimately connected with volatility, although not in the way that most people think. More volatility can reduce rather than increase market risk. Here’s how it works - and thank you to investment strategist Lyn Alden for crunching the numbers.
Imagine an investor with a portfolio made up of 70% shares and 30% bonds who over a 40-year period enjoys a steady 10% a year gain from the shares and 4% from the bonds. At the end of each year the investor rebalances their portfolio back to the original weighting by selling some shares and buying some bonds. The result is a smooth 8.2% return.
That isn’t how markets work of course, so let’s introduce some realism by assuming that the same long-term return is achieved thanks to the shares rising by 34% one year and falling 10% the next throughout the 40 years. The outcome here is slightly better than the smoother portfolio. Why? Because each time the rebalancing takes place, the investor either sells more shares when they are highly-priced or buys more when they are cheaper. The volatility works in the investors’ favour.
Let’s make the situation even more realistic by assuming that on a couple of occasions during the 40-year period, the market falls by 50% and takes three years to recover (sound familiar?). In this case the size of the end portfolio is higher than in both the other scenarios despite the overall compound rate of growth being the same. The heightened volatility provides even better opportunities for rebalancing.
This is good news for investors because it doesn’t require you to second-guess where the market is going in the short-term, merely to be disciplined about rebalancing. The even better news is that with a bit of gentle finessing, an investor can achieve a significantly better return still (twice as much, Alden calculates) - again without any need for a crystal ball.
The way to do this is simply to adjust the ratio of shares to bonds according to the last year’s returns. After good years in the market, shift to 60% shares/40% bonds; after a bad year in the market move to 80% shares/20% bonds.
It’s not rocket science, but this approach is the opposite of how most people invest. They tend to buy after shares have risen because they feel optimistic and they sell after a fall. It’s human nature but it’s bad investing.
Of course, this contrarian approach is easier to describe than to do. But it does show that while risk should always be minimised, volatility can be the investor’s best friend. Don’t be concerned by the market gyrations. Embrace them.
Important information The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.