In this article, Jim Parker of Dimensional Fund Advisers, explores the high level of volatility for 2020 that’s worth a read for investors to understand the level of extremes this year, and looks at the options of remaining calm and staying ‘in your seat’ as the wisest action for investors.
It was one of the greatest AFL games of all time.
In the 2005 quarter final against the Geelong Cats, the Sydney Swans were on the verge of elimination, trailing 23 points going into the final quarter. Then, everything changed.
The Swans half forward/midfielder Nick Davis kicked four goals in the space of minutes to grab a three-point victory for his team.
History records that the Swans went on to beat the West Coast Eagles in the grand finale to take their first premiership in 72 years.
Quarter to quarter and moment to moment, sport is unpredictable. Things can change quickly.
Swans fans who went home early that day in 2005 may still be regretting it.
Recent experience in global financial markets provides a similar lesson on the importance of staying in your seat.
In the March quarter, as the economic impact of the coronavirus pandemic hit home, equity markets tanked.
The US market suffered its worst quarter since 2008, while the Australian and New Zealand markets fell by the most in three decades.
In less than a month, most major equity indices tumbled 30% or more, while a widely watched measure of volatility briefly topped the levels seen in the global financial crisis.
By the third week of March, media headlines spoke of hedge funds going to cash on the view that the conventional rules of investing weren’t working anymore.
To return to our sporting metaphor, many investors were wondering at that point whether it was time to pack up the picnic blankets, put away the coffee flasks, rip up their tickets and head for the exits as promptly as possible.
But then came the second quarter.
Cheered by a combination of policy stimulus, hopes for a relatively brief downturn and signs the virus was being gradually contained—at least in Europe, Asia and the Pacific— markets came back almost as strong.
After suffering its worst quarter since the GFC, the US market staged its best quarter since 1998.
The tech-heavy Nasdaq index surpassed February’s record highs, while the S&P 500 jumped 20% to be down only 4% for the year by the end of June.
Australia’s S&P/ASX 300 index, having slumped 23.4% in the March quarter (its worst quarter since 1987), bounced by 16.8% in the second quarter.
This was its best quarter in 11 years and the seventh best quarter on record.
Putting both quarters together, by the end of June, the benchmark had cut its losses from more than 30% to 10.5%.
Lessons for Investors
For the average investor, there are a few points to make about this.
Firstly, these episodes of volatility, while unusual, are not unprecedented.
The single worst quarter for the Australian share market since 1980 was its 41% decline in the fourth quarter of 1987.
The single best quarter over the same period was the quarter right before that when the market rose 28%.
The third worst quarter for the New Zealand share market since 1991 was the near 13% decline in the second quarter of 1998.
Yet, six months later, it recorded its best ever quarter with a near 22% return.
When there is a lot of uncertainty, markets tend to be volatile. That’s how they work.
Trying to second guess these movements is tough.
If you’re trying to time the market, you have to get two decisions right—when to get out and then when to get back in.
Think back to the football game.
Are you going to miss the first quarter and catch up in the second? What happens if all the goals are kicked in the first 15 minutes?
The nature of market premiums is similar.
We expect them to be positive every day, but like goals in football, they don’t turn up regularly or predictably.
You have to stay in your seat to get the benefit.
Second, you can deal with this volatility by working with an advisor to ensure you have the appropriate asset allocation for your goals, risk appetite and circumstances.
An investor who was 100% in equities in the first quarter of this year would have had a pretty tough ride. But adding some bonds to the mix would have made it less bumpy.
Of course, that same investor would have enjoyed the full extent of the bounce in equities in the June quarter, but not everyone can deal with that level of volatility.
Third, most people’s horizon extends beyond a few quarters. One or two bad quarters are going to mean less if your investment destination is still years away.
If you are closer to your destination, then your advisor can gradually adjust your asset allocation to take account of that.
Fourth, just as any football fan soon learns that shouting himself hoarse at the umpire’s decisions is ultimately a pointless activity, you’re fooling yourself as an investor if you think you can control or outguess the markets.
What You Can Control
Fortunately, there are some things you can control—like how your assets are allocated across stocks, bonds and cash; like being diversified across stocks, sectors, countries and currencies; like minimising fees and taxes; and like rebalancing periodically.
But once your financial plan is made, the biggest thing you can control is your own behaviour.
On that score, there is merit in not getting too despondent when the markets are down or too excited when they are up.
That is just how markets work.
Of course, if the volatility is too great and you can’t sleep at night, that’s a legitimate conversation to have with your advisor. But it’s something to consider when you have all the facts in front of you and when emotions are not at their peak.
Like a tense sporting final, watching the back and forth in markets can be nerve-wracking, there is no doubt.
But tearing up your tickets after a single bad quarter might be a decision you regret.