Market Volatility & The Patience Principle

 

(Reprinted from the October 2015 edition of the Bath Country Journal and Richfield Times.)

 

Global markets have been providing investors a rough ride. While falling markets can be worrisome, maintaining a longer-term perspective makes the volatility easier to handle.

 

A typical response to unsettling markets is an emotional one. We quit risky assets when prices are down and wait for more “certainty.” Consciously or not, we try to time markets and thereby attempt to predict the future.

 

These timing strategies can take a many forms. One is to use market technical indicators to get out when the market is judged as “overbought” and then to buy back in when the signals tell you it is “oversold.” A second strategy might be an economic one – for example, undertake a comprehensive macro-economic analysis of the Chinese economy, its monetary policy, global trade and investment linkages, and how the various scenarios around these issues might play out in global markets.

 

In the first instance, there is little evidence that these indicator-based timing decisions work with any consistency. In the second instance, you can be the world’s best economist and make an accurate assessment of the growth trajectory of China, together with the policy response. Nevertheless, that still does not mean the markets will react as you assume. An illustration in absurdity: according to a Vanguard study, rainfall has historically actually a better predictor of future stock returns than GDP growth.

 

Another way is to reflect on how markets price risk. Over the long term, we know there is a return on capital. However, those returns are rarely delivered in an even pattern. There are periods when markets fall precipitously and others when they rise inexorably. The only way of getting that “average” return is to go with the flow. Think about it this way: a sign at the river’s edge reads, “Average depth three feet.” Reading the sign, the hiker thinks: “OK, I can wade across.” Yet, he soon discovers the “average” masks a range of everything from 6 inches to 15 feet.

 

Historical market returns are often thought of as offering “average” returns of 8% to 10%. Yet, individual year returns can be many multiples of that average in either direction. Understanding possible outcomes from your investment choices helps set proper expectations.

 

For example, look at a global stock market benchmark such as the MSCI World Index. In the 45 years from 1970 to 2014, the index has registered annual gains of as high as 41.9% (in 1986) and losses of as much as 40.7% (2008). However, over that full period, the index delivered an annualized rate of return of 8.9%. To earn that return, you had to remain fully invested, taking the unsettling down periods with the heartening up markets, but also rebalancing each year to your target asset allocation.

 

Timing your exit and entry successfully is a tough task. In 2008, the index had the worst single year in our sample, yet, in the following year, registered one of its best ever gains.

 

What has happened is already priced in. What happens next is what we do not know, so we diversify and spread our risk. For instance, while stocks have been performing poorly, bonds and managed futures have been doing well.

 

Markets are constantly adjusting to news. A fall in prices means investors are collectively demanding an additional return for the risk of owning equities. For individual investors, the recent price decline may only matter if they need the money today. Even for a retiree, not all of their accumulated capital is needed for today and some market risk generally must be assumed to outpace inflation and maintain purchasing power over time.