Investing in stocks in volatile markets isn’t easy. Uncertainty and volatility can shake the faith of even the most optimistic and experienced investors. Investors often react by changing their investment strategies to reduce portfolio volatility. Sometimes this can make sense. But keep in mind, volatility is just one of many investment risks. Risk is multi-faceted and there is almost always a trade-off. Minimizing volatility can expose you to other, potentially more profound, risks.
We believe current economic uncertainty and market volatility concerns present a good opportunity to re-evaluate risk and what it means for you and your portfolio, both in the short and long term. We have found that investors tend to focus on short-term risk, notably volatility. But if you shift your perspective and focus to the long term, risk often looks very different. For example, one big long-term risk is that your portfolio fails to deliver the growth you need to meet your goals. This often happens when people don’t have an appropriate asset allocation or portfolio strategy aligned with those goals. Or they fail to account for inflation or a long investment time horizon.
Investors tend to see short-term volatility as their biggest risk
Volatility is a measure of how much a security’s returns vary over time. A security with very low volatility will offer a relatively steady rate of return. More-volatile securities, however, have a greater dispersion of returns, as measured by standard deviation from their average. In simple terms, more-volatile securities tend to have bigger swings in price. Risk, on the other hand, is a much more expansive concept that includes all uncertainties.
There is a tendency, however, to pay more attention to risk that is right in front of you. And most commonly when investors refer to “risk,” they’re referring to short-term volatility—stock prices moving down over a few days or weeks. Watching your investment accounts drop can be harrowing, but—if you don’t need to draw from these savings in the short term—short-term volatility may not pose a big risk to your long-term goals.
For example, if your investment time horizon is 10, 20 or 30 years, then short-term ups and downs over a few days, weeks or even months shouldn’t be a huge concern. Human psychology, however, makes it hard for us to stomach even short-term declines. Myopic loss aversion, a key principle of behavioural economics, identified by Amos Tversky and Daniel Kahneman, holds that, “when directly compared or weighted against each other, losses loom larger than gains.”[i] This means we tend to find a loss more painful than we find a similar or even larger gain pleasurable. This can cause investors to go to great lengths to avoid losses, even if it means sacrificing future gains.
However, over the long term, risk is different. Whilst investors are often most concerned with short-term declines, one of the biggest risks over the long term is that your portfolio’s growth falls short of what you need to reach your goals. Given this risk, adjusting your portfolio to reduce volatility, shifting your asset allocation out of stocks too soon or trying to time the market can all be risky over the long term.
Straying from your optimal asset allocation is dangerous
Investors who need portfolio growth over longer time horizons typically own equities for their history of strong long-term growth. If you have determined you need to be substantially invested in stocks in order to reach your goals, it can be dangerous to react to short-term volatility by departing from that asset allocation. Why? The long-term annualised return of equities is 8%, whilst fixed interest has returned 6.1%.[ii] The difference between these two long-term annualised returns may seem minor and an acceptable trade-off for less stomach-churning volatility. But consider that a $500,000 portfolio invested for 20 years that grew 8% annually would have a final value of $2,330,479—whereas a similarly sized portfolio invested for 20 years that grew at 6% annually would have a final value of $1,603,568. A 2% difference compounded over 20 years can result in a sizable difference in final portfolio value. That’s why asset allocation decisions—and the discipline to adhere to a portfolio strategy—are so important.
Then, too, if you deviate from your target asset allocation by selling some or all of your equities, you’ll face a second perilous decision: When should you reinvest in equities? In a month? When the market calms down? When everything feels safe? Unfortunately, in the short term, the stock market is almost impossible to predict and any attempt at market timing may be riskier than a buy-and-hold strategy. Stock market returns are highly uneven and it’s not unusual to see big gains in just a few trading days. Given that missing a handful of these big “up” days can be costly, we believe it often makes more sense to stay invested in equities.
Lastly, it is important to remember that a stock market correction—a sharp, sudden drop of -10% to -20%—is often followed by a recovery that is just as sharp and sudden. To benefit from selling out of equities during a correction, your timing would need to be impeccable. You would need to sell some or all of your equities early enough to dodge a substantial portion of the downturn. And you would need to buy back in so as not to miss out on the rebound. We know of no investor consistently able to do so. If you sold out of stocks too late or bought back in too late, you may have ended up experiencing a good deal of the downside and missed out on a substantial portion of the recovery. We believe the takeaway is, if you try to time equity markets to avoid short-term declines, there is a great likelihood you do yourself more harm than good.
Short-term volatility is a risk. But depending on your investment time horizon, it may not be your biggest risk. Quite simply, for many investors, the biggest risk is failing to achieve the growth they need to meet their long-term goals. Moreover, focusing on short-term risks alone may mean ignoring or increasing your long-term risks. Though it may be tempting at times, deviating from your optimal long-term asset mix just to reduce short-term volatility can make it less likely that you achieve the growth necessary to reach your long-term goals. We believe long-term investors should invest for the long haul and focus more on risks to their goals and less on shorter-term worries over volatility.
[i] Daniel Kahneman. Thinking, Fast and Slow, (New York: Farrar, Straus and Giroux, 2011), 282.
[ii] FactSet, Global Financial Data, as of 13/02/2019. MSCI World Index, 31/12/1969–31/12/2018. Domestic 10-Year Government Bonds, 12/01/1932–31/12/2018. All data are in GBP. All equity and bond returns are total returns. The comparative results could be different if the same time periods were used. Time periods vary due to the availability of reliable data.
Fisher Asset Management, LLC does business under this name in Ontario and Newfoundland & Labrador. In all other provinces, Fisher Asset Management, LLC does business as Fisher Investments Canada and as Fisher Investments.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments Canada and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments Canada will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
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