Why You Should Not Fear Volatile Markets

30 August 2019

Investors are anxious again.

It’s only to be expected: US-China trade talks are back on, while the spat continues; the US markets recently hit all-time highs, but many investors forget that it’s only the US, not the whole world, and it is denominated in US dollars; everyone is waiting for a rate cut; and profit warnings from Chinese companies are spooking investors banking on growth.

These dramatic-sounding headlines and soundbites are everywhere these days, and heightening everyone’s fear that this could be the end of the cycle. What should investors do?

Logical, tidy-sounding theories always abound when it comes to what is driving market direction. It comforts us to know that there is method to the madness. Our brains are hard-wired to find causes for the effects we observe. Nobel laureate Daniel Kahneman calls this our “System 1” thinking – our automatic, fast-paced and unconscious way of thinking that helps us survive in dangerous situations.

However, when it comes to situations requiring logical and rational thinking, such as money, that same System 1 thinking can be our downfall.

For example, it can push investors to want to act “before” something happens in the markets: to sell if they expect prices to fall, or buy if they expect prices to rise. But the reality is that no PhD, CIO or super-analyst will be able to tell you for certain what is going to happen next. This is the nature of risk. It is this risk that we as investors have to take in order to achieve a return. Making decisions about your long-term financial health based on daily, monthly or quarterly events is completely unproductive and potentially damaging.

Nonetheless, if current market conditions still trouble you, here are 5 simple truths that could help you accept and live with this volatility:

1. Someone is Always Buying

Running away from unpredictable or falling prices is running away from a sale. Would you flee in terror if your dream bag was suddenly going for 50% off? If not, you should treat stocks the same way!

When prices fall to reflect higher risk, it’s another way of saying that future expected returns will be higher. And if headlines proclaim, “Investors are dumping stocks”, always remember that it means someone is buying. If nobody was buying, prices would have fallen to $0, because there would be no demand. The investors buying when prices are falling are the astute long-term investors.

Warren Buffett once famously said, “The true investor welcomes volatility – a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.”

2. Market Timing is Completely Unreliable

Recoveries come as quickly (and possibly as violently) as market sell-offs. We have written about how the best days of the market are always among the most volatile days.

Statistics also show that market sell-offs aren’t as terrible as reports make them out to be, and that markets spend 70% of the time going up, while only 30% going down. Why would you want to sit out of something that goes up the majority of the time?

Recent corrections like that in December 2018 – or even the terrible crash of 2008 – are prime examples of how getting out turns paper losses into real ones. After the 2008 crash, markets spent the next 7 months going up, and the collapse of 2018 was followed by a complete recovery in 5 months.

3. Never Forget About the Power of Diversification

When equities turn rocky, very high-rated government bonds will do well. This limits the damage to investors who balance out their portfolios with properly diversified fixed income. Global diversification – such as holding 10,000 securities – helps investors immensely as well, as it prevents the portfolio from collapsing. Imagine if you had bought and held 20 technology names during the dotcom bubble, only to see 95% of your wealth get wiped out during the crash.

4. Markets and Economies are Different Things

If you’re fearing an economic downturn and want to get out of the market, hang on for just a moment. Research shows that the relationship between the economy and stock market can actually be negative – meaning that falling economic growth = rising stock prices, and vice versa!

While this may not happen all the time, it just shows how difficult it is to predict the direction of the market. The global economy is always changing, and new forces are replacing the old ones. Investing in the 70s meant loading up on oil and commodities, industrial companies and railroads. The stock market these days has a large proportion of technology companies and financials.

Investors who invest in an indexed manner will automatically invest in new and upcoming areas of the world without needing to predict where those new areas of growth would be.

5. Nothing Lasts Forever

Astute investors try to temper their enthusiasm when the market is nicely running up, just as they keep a reserve of optimism during market busts. Always be neutral and don’t let your emotions take over.

Remember why you invested (or wanted to invest) in the first place. Was it to replace your income? Save for a big purchase? Help out your family, perhaps? Going back to your goals will prevent you from loading up on risk when prices are high, as well as keep you from unnecessarily dumping those assets when prices are low.

As in life, do everything in moderation.


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GYC Perspectives

Markets are often irrational. Even among experts, forecasting does not consistently work. We instead believe in Evidence-Based Investing (EBI), which uses decades of empirical data and the greatest ideas in financial science to optimise investment outcomes. No market predictions, no forecasts, no emotions. All those things rely on gut-feel and intuition that cannot be consistently replicated.

Here, we share with you the evidence on why EBI works and why forecasting doesn't, as well as articles on topics such as behavioural finance to help you become better investors. New here? You can start with this introduction to EBI. Happy reading!

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