For investors in equity, bond and property funds volatility of value is an occupational hazard. In fact volatility is normally viewed as negative, a risk to be avoided if possible. This has led to a proliferation of volatility managed funds in the last few years which have targets for limiting downside movements in prices, so much so that the Investment Association, who group funds with similar investment mandates, permitting meaningful comparisons of performance, have recently created a brand new sector to accommodate them.
Volatility only damages portfolio returns if investors sell funds during the troughs as they may end up crystallising losses. Until then they are sitting on paper losses. If they ignore the short term noise and sit tight their equity investments normally recover and deliver good returns in the longer term. It is for this reason that investors need a cash buffer, accessible savings that avoid them becoming forced sellers at bad prices. Of course you could invest entirely in cash where there is no volatility. Although very cautious risk investors might sleep well at night during a stock market crash they are exposed to a different type of risk. With paltry interest rates, cash is unsuitable for income and in time its real value or purchasing power is eroded by inflation. Cash is not a great asset to be 100% invested in for the long term.
All this is standard stuff which you have probably heard me say before, however over the weekend I read an interesting article with some interesting new perspectives on volatility. It was written by Didier Saint-Georges, managing director and member of the investment committee of Carmignac Risk Managers. He argued that an asset moving in opposite directions quickly, the meaning of volatility, does not mean it is fragile. It could be a sign of flexibility. In contrast a stable asset might collapse suddenly or lose value little by little. Saint-Georges gave the example of safe-haven German government bonds. Investors expecting stable values and very low volatility got a shock when German bond prices fell 9% between 20 April and 10 June 2015 due to a brighter outlook on the European economy. He also cited Bernie Madoff’s pyramid investments which had extremely low volatility. This should have been a red flag for savvy investors. Saint-Georges referred to these examples as the “Turkey Syndrome.” A turkey fed regularly through the year comes to view the world as a stable and predictable place until the week before Christmas when this state of affairs proves to be an illusion!
There are other benefits of volatility. First it may help remove some of the froth in equity valuations – this is euphemistically called a “correction.” It may also drive out speculators who pile in to a good story and drive a wedge between prices and fundamentals. The classic example here was the technology bubble of the late 1980s. We all know how that ended. Conversely a sharp fall in a stock may be a sign that investors have sold out irrationally and have misjudged its true value, providing an opportunity for fund managers to add to their best holdings at lower prices. Finally if an index crashes it may signal a good time for investors to deploy cash to the market. Volatility does not need necessarily need to be seen as a foe.
The content of this blog is my own understanding of market volatility in part based on Carmignac Risk Managers’ article “Volatility is not to be feared.” My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.