October 28, 2014 | By Jim Parker, Vice President DFA Australia Limited
Volatility is back. Just as many people were starting to think markets only ever move in one direction, the pendulum has swung the other way. Anxiety is a completely natural response to these events. Acting on those emotions, though, can end up doing us more harm than good.
There are a number of tidy-sounding theories about why markets have become more volatile. Among the issues frequently splashed across newspaper front pages: global growth fears, policy uncertainty, geopolitical risk, and even the Ebola virus.
In many cases, these issues are not new. The US Federal Reserve gave notice last year it was contemplating its exit from quantitative easing (an unconventional monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective). Much of Europe has been struggling with sluggish growth or recession for years, and there are always geopolitical tensions somewhere.
In some ways, the increase in volatility in recent weeks could be just as much a reflection of the fact that volatility has been very low for some time. Investors in aggregate were satisfied earlier this year with a low price on risk, but now they are applying a higher discount rate to risky assets.
So the increase in market volatility is an expression of uncertainty. Markets do not move in one direction. If they did, there would be no return from investing in stocks and bonds. And if volatility remained low forever, there would probably be more reason to worry.
As to what happens next, no one knows for sure. That is the nature of risk. In the meantime, investors can help manage their risk by diversifying broadly across and within asset classes. We have seen the benefit of that in recent weeks as bonds have rallied strongly.
For those still anxious, here are seven simple truths to help you live with volatility:
#1 Don’t make presumptions:Have you noticed how people become experts after the fact? But if “everyone” could see a correction coming, why wasn’t “everyone” profiting from it? You don’t need forecasts.
#2 Someone is buying: People often gravitate to the familiar and to shares they see as solid. But a company’s profile and whether or not it is a good investment are not necessarily correlated. Better to diversify.
#3 Market timing is hard: The emotions triggered by volatility are understandable, but acting on those emotions can be counterproductive. Uncertainty goes with investing. Historically, long-term discipline has been rewarded.
#4 Never forget the power of diversification: People often assume that success in investment requires a specialist’s knowledge of a sector. But that information is usually already in the price. Trust the market instead.
#5 Markets and economies are different things: Isn’t that the point? You can rationalize a stock-specific bet as much as you like, but events or external influences can conspire against you. Spread your risk instead.
#6 Nothing lasts forever: If an economy performs strongly, that will no doubt be reflected in stock prices. What moves prices is news. And news relates to the unexpected. So work with the market.
#7 Discipline is rewarded: We can put too much faith in individual stocks, and holding onto a losing bet can mean missing opportunities elsewhere. Portfolio structure affects performance.
‘‘Outside the Flags’’ began as a weekly web column on Dimensional Fund Advisors’ website in 2006. The articles are designed to help fee-only advisors communicate with their clients about the principles of good investment—working with markets, understanding risk and return, broadly diversifying and focusing on elements within the investor’s control—including portfolio structure, fees, taxes, and discipline. Jim’s flags metaphor has been taken up and recognized by Australia’s corporate regulator in its own investor education program.
Diversification does not eliminate the risk of market loss. Past performance is no guarantee of future results. There is no guarantee that strategies will be successful.
The S&P 500 Index is not available for direct investment and does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.
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