Just as many people were starting to think markets only ever move in one direction, the volatility pendulum swung swiftly the other way over the last few months. Various markets have made significant moves up and down and sometimes back again in relatively short order.
There are a number of tidy-sounding theories about why markets have become more volatile. Among the issues frequently splashed across newspaper front pages: global growth fears, policy uncertainty, geopolitical risk, and even the Ebola virus.
In many cases, these issues are not new. The US Federal Reserve gave notice last year it was contemplating its exit from quantitative easing. Much of Europe has been struggling with sluggish growth or recession for years, and there are always geopolitical tensions somewhere.
In some ways, the increase in volatility could be just as much a reflection of the fact that volatility has been very low for some time. Investors in aggregate were satisfied with a low price on risk, but now they are applying a higher discount rate to risky assets as these risky assets have increased in price and become more expensive. Many risky assets – U.S. equities of particular note – now have a correspondingly have lower expected return and less safety margin to shoulder potentially bad news.
Here are seven simple truths to help you live with volatility:
Don’t make presumptions. Remember that markets are unpredictable and do not always react the way the experts predict they will. When central banks relaxed monetary policy during the crisis of 2008, many analysts warned of an inflation breakout. If anything, the reverse has been the case with central banks fretting about deflation.
Someone is buying. Quitting the equity market when prices are falling is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. For every seller, remember someone is buying. Those people are often the long-term investors.
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 worst—the S&P 500 turned 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 risk without receiving the reward.
Never forget the power of diversification. When equity markets have turned rocky, highly rated government bonds have flourished. Diversification spreads risk and can lessen the bumps in the road.
Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. This applies both between and within economies. For instance, falling oil prices can be bad for the energy sector but good for consumers.
Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And 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. Moderation is a good policy.
Discipline is rewarded. Market volatility is worrisome, no doubt. The feelings being generated are completely understandable and familiar to those who have seen this before. Through discipline, diversification, and understanding how markets work, the ride can be made bearable. Having a well-constructed and understood financial life plan and the clarity and confidence that it brings in linking your money to your values and your lifestyle may be the best crutch one can have to maintain discipline. At some point, value re-emerges, risk appetites reawaken, and for those who acknowledged their emotions without acting on them, relief replaces anxiety.
Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs. This article adapted with permission from Jim Parker of Dimensional Fund Advisors.
