When Volatility Climbs Back Into the Ring

Volatility is back this year. While portfolios may take a few hits, investors unlikely to be felled by a knockout blow.

  • Volatility has returned this year, but that is not unusual or necessarily a bad thing
  • Asset prices have historically gone up and down with more frequency, and by larger amounts than last year
  • Investors should be prepared to tolerate some volatility and its impacts in the short term
  • Volatile markets shouldn’t encourage erratic behaviour – history has rewarded cool heads and a coherent long-term investment strategy designed to suit their goals
  • An approach based on sensible, strategic decisions and minimising costs will deliver rewards

So far, 2018 has offered a very different experience for investors than the calm of 2017. A number of concerns that were building up in the minds of investors about market levels, the outlook for interest rates and President Trump’s trade policies finally broke through into market pricing. This impacted returns across a wide array of asset classes.

One consequence was that many markets, including the major equity indices such as the FTSE 100, finished the first quarter in the red. Another was a rise in market volatility. Low volatility had been a characteristic of the markets in recent months, reflecting predictable economic and policy conditions despite some headline-grabbing political events. The most-followed measure is the VIX Index1 shown in the chart below.

Source: Bloomberg, Netwealth calculations
* Returns in US dollars

What do we mean by volatility?

Volatility measures how much market prices fluctuate. Often price movements can be larger in negative markets than they are in rising ones, but the main message is that volatility rises at times of uncertainty, or when there are differences of opinion about what lies ahead.

Weekly performance of UK equities

Source: Bloomberg, Netwealth calculations
Weekly returns for FTSE All Share Index for the period 31st December 1999 to 20th April 2018

One challenge is that sharp negative movements in markets are often mixed among strong positive ones – and missing out on a small number of the biggest daily returns can materially impact portfolio performance, even over the long run. For instance, even over a 30-year period, missing the 10 best trading days for an investor in the US equity market reduced the total returns generated from 933% to 3992, due to the missed opportunity for compounding.

As investors cannot expect to pinpoint the weeks, or even days, when markets will excel, a far ‘safer’ proposition is to remain invested through bad and good times. There is also a widely held perception in the industry this is made all the more challenging by investors’ ‘loss aversion’, an effect which can be summarised as losses hurting far more than equivalent gains feel good.

What is normal volatility?

Given that market behaviour will change through time, what might be viewed as ‘normal’ volatility? Recently, we described how the number of days with large US stock market movements in the first quarter of the year reflected a return to normal market behaviour, being more typical of past experience than 2017. More days with large moves is nothing to be scared of, but to be expected.

Number of days with large US stock market moves per quarter

Source: Bloomberg, Netwealth calculations
Refers to number of trading days with a move up or down by the S&P 500 Index of more than 1%

Investors should also expect periods where market returns are less favourable for an extended period of time. Again, using history as a guide, most of the past 25 calendar years have seen equity markets sustain losses at some point without damaging investor returns for the year as a whole. Starting from 1993, investors in the FTSE All-share index saw losses of at least 5% from their starting point on January 1st in 14 of the 25 years, but this does not mean that performance in each of these 14 years was poor.

The following chart reflects this. It shows for every year since 1993, the biggest drawdown (that is the low point versus the start of the year) and the eventual outcome. Although there were clear periods when the typical investor experience was particularly painful, not every market wobble leads to a bear market like those periods shaded in red on the chart below.

FTSE All-share: Calendar year total returns vs intra-year drawdowns

Source: Bloomberg, Netwealth calculations

“Everyone has a plan ‘til they get punched in the mouth”

Perhaps Mike Tyson isn’t the most obvious person to turn to for thoughts on financial planning3, but one of the most dangerous risks of investing is to be over-committed at a point of market pain. That’s why we emphasise the willingness and ability to tolerate losses when discussing appropriate portfolios for clients to invest in. While few of us would have the pain threshold required to face a heavyweight in the ring, we do need to think about our tolerance for portfolio losses, as crystallising such losses by selling assets after periods of volatility is a guaranteed way to permanently impair performance.

What’s your pain threshold?

One of the best expressions of an investor’s tolerance for risk is the magnitude of ‘peak to trough’ losses, or drawdowns, they are able to withstand. It is therefore a metric we look at closely when building portfolios and is a valuable way to place historic ‘worst outcome’ returns of different asset classes into perspective. Importantly, these losses will prove to be only paper losses if an investor does not sell and, in time, markets recover.

In the charts below, we show the history of all negative performance periods for three of our diversified Risk Levels’ strategic allocations. Each downwards spike on the charts shows the magnitude of a peak to trough return. As we are trying to highlight the fact that markets can decline, we have decided to deliberately ignore periods of performance that deliver returns above previous high points. In this way, the charts aim to disregard the upside, and clearly illustrate the risks of investing in a given portfolio – they represent a very visual sense of what falling markets can mean in practice.

Historic drawdowns 1993 - 2017 Risk Levels 2, 4 and 6 Strategic Allocations (net of fees)

Source: Bloomberg, Netwealth calculations

We like these charts for a few reasons. Firstly, and most importantly, they emphasise how sharp falls can be in volatile periods, even for a diversified portfolio. For example, if an investor had invested in a Risk Level 4 portfolio at the market highs in the Tech Boom of 2000 or the pre-Financial Crisis peak of 2008, they could have seen losses of more than 15% or 20% respectively. The charts also give an indication of how the time taken to recover losses can vary, depending on market conditions.

Taking the experience of our Risk Level 4 investor again, the portfolio took approximately half as long from the trough to recover all the 2008-09 losses as it did those of 2000-02, even though the fall in value had been worse. Clearly, selling out of portfolios at either of these troughs in performance would have been very damaging to returns.

A final point to note when looking at these charts is how much time portfolio values have spent either falling or recovering from falls – even in a period of significant cumulative returns: between 5.2% and 7.1% per annum for the three Risk Levels shown. In other words, the lines in the above chart spend very little time at the 0% line, when the Risk Levels were reaching new heights. This emphasises how infrequently investors should expect to see their portfolios at all-time highs.

Volatility doesn’t mean underperformance

So, should cautious investors with a reasonable investment horizon shun the volatility that investing brings? The answer is no. The usual alternative to taking on market risk is to accept the interest rates offered on cash deposits – and history shows how risky this can be as a long-term solution to building or preserving wealth.

Holding cash was only successful 19% of the time relative to the balanced portfolio over 5-year holding periods, 8% of the time over 10-year periods and was never successful over periods of 20 years or longer. Staying in cash might be more reassuring, but over multi-year horizons it is unlikely to be rewarding – even when market conditions go through difficult periods. The security of cash is also largely illusory when one considers the impact of inflation on any cash over time.

Percentage of periods since 1970 that GBP cash has beaten riskier assets

Source: Bloomberg, returns to calendar year ends between 1970 and 2017

Volatility matters for investors, and there are a number of ways to think about it when observing markets, planning your personal investment strategy and constructing portfolios. Accepting that markets will throw challenging periods at investors is one of the most important aspects to benefitting from the opportunities they bring – and navigating through them rather than being left out of pocket.

Understanding one’s pain threshold and adopting an appropriate amount of risk is vital, in order to avoid selling at the worst time or underinvesting to the detriment of longer-term returns. Having an experienced team in your corner to maintain a strategic focus and oversee day-to-day decisions with a cost-aware approach is the most effective way to get through normal, volatile markets.

Please remember that when investing your capital is at risk.

1 The VIX Index is a measure constructed by the Chicago Board Options Exchange that is used to estimate the future volatility of the US equity market, as implied by a range of options on the S&P 500 Index.
2 Source: Bloomberg, Netwealth calculations.
3 ‘Iron’ Mike was declared bankrupt in 2003, owing $23 million, despite having earned an estimated $300 million during his career.

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