4CRB: Can I handle market volatility?

Market volatility – So what is it?

In relation to shares or super it is the daily movements in the share price of the underlying investments. They move each day and minute that the markets are open because it is a free market.

A good way to think of it is the lowest price someone is willing to sell their shares for. That is what the purchaser is paying.

Most movements in share prices come from outside events from the world in the short term and over the medium to longer term they should come from the characteristics of the company.

Why accept market volatility?

To compare the difference in returns over time, in the following example from 1 January 2010 we can see the returns in an index were:

Cash: 2.4%
Australian Shares: 7.5%
International Shares: 12%
Balanced Approach: 6.6%
Growth Approach: 7.8%

Source: Vanguard

Volatility in markets can be challenging for investors. Each year we see different asset classes that are the better performers and whilst we can’t control what markets do we can understand why they are volatile and strategically invest and adjust portfolios if necessary to take into account the current market conditions.

Accept Markets operate in Cycles.

In understanding volatility it is important to accept and understand that markets operate in cycles. The following is an example of a typically how an investment cycle run.

Here is what our DNA is wired to:

While markets have cycles so do investors. Following is an example of how investors can think and react during market volatility.

As we mentioned earlier, we can’t control markets so it’s important to focus on what we can control and how we react. Perhaps ask yourself the following:

What type of investor are you? Are you a day trader and trying to make money out of the short term? If yes, then you need to be reacting and doing something.

Is the company you are invested in really worth less today than it was yesterday if the share market goes down?

Why would you sell your shares today for less?

If you decide to sell, when will you know when to buy back in?

More often than not markets will have recovered but individuals have not. The difference is they reacted or over reacted. Then they did not reverse this decision.

If you sell today, it should be because you hope to buy back in at a dip. If the market drops further you will buy back in or you’ll wait for it to recover to a point where you feel safer investing. MOST PEOPLE END UP BUYING BACK IN AT A HIGHER AMOUNT OR NOT AT ALL, BLAMING MARKETS FOREVER.

How to stay calm during market volatility…

During periods of market volatility, while it can be difficult, it is important to stay calm to avoid overreacting and ending up in the “investor cycle” that we showed earlier. We understand that sometimes this can be easier said than done, so the following are some points around how to manage this:

Understanding volatility and what it means. We mentioned earlier about how it is important to understand why there is volatility, how this works and what effect it has on your portfolio. There are a number of publications on the website that can help explain this or your adviser is also a perfect resource to help with education in this area.
Focus on goals. What is your long-term goal you are trying to achieve? By focusing on your set goals, this will help to ensure that the current market conditions are not side-tracking you and you’re not making rash decisions that may not help you to achieve your more distant goals that are important to you.
Following on from this point you also need to stick with your financial plan that you have in place. Short term volatility will often even out and if volatility is persisting long term then your adviser can assist with strategies to help counter this and allow you to pass the sleep test at night.

Options for investing…

Insource:

This involves timing markets and buying and selling based on daily volatility and what you are seeing or reading.

To invest this way means you need time. You need time to watch and study the markets and also to research companies. You need to understand the right time to get out, and the right time to get in.

Not everyone has this time and patience.

Investing this way generally means that you change your style and approach over time.

Outsourcing…

Select a professional approach and let them implement a long-term investment philosophy, allowing for the market to ebb and flow over time.

Whilst your investment decision-making is limited using outsourcing, it will save you time compared to insource investing.

You can select a low-cost solution via index, active solution or a personal solution.

Industry funds are a great example of this approach. They have their approach, and they will stick to it over time.

Personally, I chair an investment committee for models that manage over $1 billion of private client’s money.

We have structured model approaches, and we will stick to these robust approaches over time.

What risk are you taking?

When considering your options for investing you need to understand what kind of risk you are taking and what kind of risk you are willing to take.

A general rule of thumb is that generally the lower return you would expect to receive on an asset generally means lower risk. That doesn’t always mean though that the highest risk equals the highest returns. Let’s review some basic approaches.

Cash and term deposits

The most simplest form of investing is cash and term deposits. These are considered to be very low risk but equally the lowest return compared to other asset classes.

Property investments

Property is considered to be a higher risk compared to cash and term deposits but less than equity style investments ie. Shares. Property investments can provide tax benefits and capital growth but with direct property you can experience liquidity issues.

Conservative fund

These are not all the same as there may be a lot of bonds within their allocation and in this cycle that is not where you want to be invested. You need to know what exactly the fund managers are investing in.

Real Return approach

This is an approach that will provide a lower longer return but will provide lower volatility. For example, it will drop less when markets pull back. I cannot provide specific examples as the information today is general in nature but I would encourage you to speak with your adviser about your options.

Balanced fund

Not all balanced funds are the same. In this market you will find out that some have an asset allocation of 50% income assets and 50% growth assets, whereas others can be 20% income assets and 80% growth assets. You need to pay particular attention to the allocation as that will have a huge effect on the volatility.

Growth fund

This will have around 10% defensive and 90% into growth assets. This will have more volatility as it is trying to achieve a longer-term higher return.

Australian and international broad funds

These are funds that are 100% exposed to markets and market movements. These will move a lot with volatility. There is also some that have risk overlays to reduce risk and others that do not. You need to know what you are investing into and what the manager is doing.

Sector funds and themed exchange traded funds (ETF’s)

These are the most volatile. These will move a lot on sentiment however they can produce large returns both positive and negative.

How do you put all of this together?

There are a few simple ways to approach all of this:

Bucketing Approach 1

Bucket 1 Defensive Bucket

Break your investments into timeframes.
Year 1-3 of what you may need is in the defensive bucket.

Bucket 2 Medium Term

These are the 3-5 year investment timeframes on funds that you may need.

Bucket 3 Longer Term

This is your longer-term investments that can have more volatility as you want to try and achieve a higher average longer-term performance.

Bucketing approach 2

Bucket 1 Defensive Bucket

Have your 1-3 years income needs set aside in cash and term deposits or investments that cannot go backwards.

Bucket 2 Balanced Bucket

Have the remainder of your investments in a balanced approach and allow a professional manager to take care of this for you.

When building an investment portfolio, we consider the following key tips that you should consider:

Diversify your portfolio.
Set a clear investment strategy.
Avoid constant market timing.
Maintain a cash buffer.
Regularly rebalance your portfolio.
Use dollar cost averaging into investments (see below).
Stay away from making emotional decisions.
Use professional managers who have teams that do this every day.
Avoid chasing last year’s winner.
Seek advice. A professional should do all of these for you.

Can I smooth the volatility out?

Our philosophy is that all new money invested should be invested a little bit per month over a number of months. This reduces the risk of when you enter the markets and is called dollar cost averaging.

Take some profits: We adopt a quarterly reweighting approach for all of our clients. That is, in positive quarters we look to sell some of the better performing assets and buy some more defensive assets. Then when we have negative quarters we do the opposite. We sell the defensive assets and buy the growth assets at a discount.

A balanced approach will help smooth the return out.

We also suggest people hold 1-2 years of cash buffer at all times. This allows you to get through the negative periods in markets.

Not every investment allows you to, but ideally, if you can separate the income generated from the growth this can also help smooth out your volatility over time. (Think of it like spending the rent and leaving the house there).

Why do people lose money?

In our experience, we have seen that people will:

try to time markets;
agree that they will accept the potential for a negative return from time to time to get an average higher return and then as soon as there is a negative they change their mind and cash in, then wait for markets to recover and then buy back in;
buy too much of one investment;
invest too much into an illiquid investment;
not accept that in markets there will be negative years.

Personal Bias controls our decisions – some people become anchored on a stock or a position, others sell at the bottom and never invest again. History would show a long-term approach without tinkering would have delivered a good result.

And finally…AVOID GURU CALLS!

In the following graph you can see a sample of the index investment approach over time.

Let’s look at falls greater than 10%

The following chart shows the difficulty in trying to invest into last year’s best performer. As you can see, the best performing asset class is generally not the best in the following year.