Swings, Roundabouts and Rollercoaster Rides

Swings, Roundabouts and Rollercoaster Rides

If you were to draw a line on a piece of paper that represented the growth of the global economy over the long term, it would be unusual if it were a straight line from the bottom left to the top right. 

There would be some wiggles and humps, or some peaks and troughs, along the way.

These curves are what economists refer to as volatility. Volatility does not measure the direction of market values, only their dispersion. Two instruments with different volatilities may have the same expected return, but the instrument with higher volatility will have larger swings in values over a given period of time.

Oddly enough, there is rarely any market or media commentary on volatility when the trend is upward. After all, that’s what markets always do over time.

Investors begin to take notice when trends are flat or falling. This could lead to costly emotional responses, but the key here is that volatility is not the enemy of investors.

The most simple but effective explanation I have come across that visualises long-term volatility is this:

Imagine stepping on the bottom of an escalator while playing with a yo-yo. As you rise to the floor above, the yo-yo goes up and down on a regular basis, all the while rising with the escalator.

“The psychologists Daniel Kahneman and Amos Tversky have shown that when humans estimate the likelihood or frequency of an event, we make that judgement based not on how often the event has actually occurred but on how vivid the past examples are.”

Benjamin Graham

Market volatility can occur at any time, so it makes sense to understand it and alleviate any fears of the unknown.

Bulls and Bears

A bull market refers to major upswings in the markets, while a bear market is a pronounced market downturn. Bull markets often correspond to periods of economic and job growth; bear markets are often tied to periods of economic decline and a shrinking economy. 

Volatility exists equally during bull and bear markets.

Bear Markets

Bear markets, marked by a market decline of 20% or more, can occur for various reasons, such as a weakening economy, a stock market bubble, a geopolitical crisis, or a pandemic. 

The economic data covering almost 100 years (to 1926) shows that the average duration of a bear market is 18 months.

Bull Markets

A bull market is an extended period of rising stock prices. Using the same data source, the average duration of a bull market is seven years.

In essence, to enjoy the historic positive returns generated by bull markets, investors must sit out the bear periods. These market ‘lulls’, whilst sometimes inconvenient or even worrying, are usually precursors of the next bull wave. 

The biggest threat with (downward) volatility is the emotional and possibly irrational response of the investor. Don’t capitulate and sell at or near the market bottom.

What should investors do when the global economy looks shaky? Here are a few useful tips.

Stop looking

Hide away in a log cabin in the woods, or relocate to a remote desert island!

Joking aside, it is best to avoid any media noise on the subject. Whether you are scrolling on your smart device, watching the news on TV, or listening to the radio, the media craves your attention at all times.

This usually means outlandish headlines or clickbait. But the media don’t know you, what’s in your investment portfolio, or what your plans and objectives are. 

Bad news sells more advertising. There is rarely any education or informed opinion in the noise.

Search any digital news source on any given day, and there will be the usual tropes about falls, crashes, losses, recessions, collapses, tumbles, etc. 

This ‘news’ is every single day, and yet serious investing is for decades.

Annually is usually enough

Any portfolio valuation will probably be different tomorrow.

There are only three possible outcomes after all: Up a bit, about the same, or down a bit. 

The last of these three options is not a financial ‘loss’. The valuation is digital or on paper. It is simply a movement in value at a point in time.

A loss can only be created by selling an asset at a value that is lower than what it was bought at. This turns a paper loss into a real loss. And then the resultant money needs to find an alternative home, which isn’t easy to predict.

Over longer periods of time, investment portfolios typically move from the bottom left to the top right (with wiggles).

Using data from FinaMetrica sourced from January 1970, let’s look at a traditional 60/40 portfolio (that is, a blend of 60% in shares and 40% in bonds – a typical mix.)

The evidence is clear based on the frequency of observations. An investor (A) looking at their portfolio each and every month can see it falling in value 37% of the time and recovering from a fall 21% of the time. 

This is bound to make them feel miserable!

Investor (B), who looks at the very same portfolio just once a year, sees a different picture.

 Their portfolio is rising 81% of the time and recovering 2% of the time. This should make them feel pretty content.

Don’t just do something; sit there

Some idioms in life need to be turned around.

The urge to act or react and actually do something is a very powerful and basic human emotion. Should you buy, sell, double down, hedge, switch, transfer, or cry? 

Investing is for the long haul and should have some powerful attaching objectives. If there is a plan, stick to it. Discipline and patience will ordinarily do the trick.

“All equity market declines are temporary and eventually give way to the resumption of the permanent advance. 
Permanent loss in a well-diversified portfolio is always a human achievement of which the market itself is incapable.”

Nick Murray

A Plan and Planning

This is where nouns and verbs become symbiotic.

For long-term investing, having a documented plan in place is important. It acts as a formal reference point for future goals and objectives.

From that point on, planning becomes more effective as changes occur in life. Planning allows you to be versatile, nimble, and adaptive to change. 

Economies rise and fall, popular sectors such as retail can morph overnight, and then there is currency, inflation, interest rates, and taxation to contend with.

Those investors with a plan who regularly include planning tend to do better over time than those who do not.

Get a Coach

The popular African proverb says that if you want to go fast, go alone, but if you want to go far, go together. Investing shouldn’t be fast.

Having a fellow traveller who can act as a guide, coach, mentor, and sounding board is invaluable. They will help you make the right decisions and hopefully come between you and an otherwise dumb decision.

Enjoy your journey.

Don Fraser

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