Wednesday, 6 March 2013

Market Volatility

Conventional wisdom says investing in equities is more of a risk than bonds.

Well, if you are dipping in and out of the stock market trying to time your trades, you will almost certainly get caught out sooner or later so, yes more risky.

If you’re paying over the odds in charges on your investments, your returns will suffer so, yes - again more risky.

If you are hoping to make a quick profit on the markets over the next year or two, again you may be lucky but the chances are you will run a high risk of losing some of your investment.

Finally, you choose low cost investments, your money is being drip-fed into your investments on a regular basis - your plan is to invest for the long term… sounds good so far….suddenly, out of the blue, the stock markets turn negative, your investments lose 20% of their value within days…panic, anxiety - what to do - sell now? Maybe hold on a while - sell when you get back to somewhere what you paid? Sell half now and keep your fingers crossed the remainder will turn out OK?

I believe this aspect is one of the key reasons why many private investors fail to achieve more success from their investing and this is why having some understanding of volatility of both the markets in general as well as individual shares is one of my 5 ‘basics’. When anxiety and fear suddenly enter the arena, its far more difficult to think rationally and make the right decisions.

As a species I guess we are not very well equipped to deal with uncertainty, so perhaps the answer is to approach investing from a position of absolute certainty - markets will go up… and then go down. The other certainty is that no matter how far the markets fall, and then fall some more, in the long run they always bounce back.

In the UK, we tend to focus on our own little corner of the World - in stock market terms, this usually means the FTSE 100. There are some pretty large companies listed on the FTSE - HSBC Bank, Vodafone, Shell Oil, Tesco - are familiar names. However, the UK market makes up only around 8% of the global stock markets which are dominated by the USA with 45%. Other significant markets are Japan 7%, Canada 4%, rest of Europe 16%, Australia 3% - surprisingly China only accounts for 2%. (Source - Credit Suisse Yearbook).

Markets rise and fall - often there is no obvious reason - just look at the rise of around 10% on the FTSE in the first couple of months of this year - why? These global markets are all closely interconnected and will tend to rise and fall in unison taking a lead from the dominant market of USA. Of course, we all like to know why things happen the way they do and we like to see patterns which may give us a clue as to how things will pan out in the future - its probably hard-wired into human DNA. All I’ve been able to work out is that markets are volatile - sometimes they go up and sometimes they are flat within a range and sometimes they fall. If you are investing on the stock market to secure a better return than cash deposits, you need to accept this volatility as part of the deal.  

Eureka!

The big light bulb moment in my investing career was to make the distinction between prices - markets, shares etc. - and yield, pretty obvious really.

Markets and share prices are volatile - sometimes extremely so like the sharp decline at the end of 2008. If you focus on day-to-day price movements, its not difficult to see that you may lose your nerve at times. Alternatively, its not difficult to understand why some investors will be tempted to ‘take profits’ after a strong market rally. I will look at market timing in a future article, but for the long term investor, I firmly believe the rewards will come from sticking with the market through thick and thin. In his recent Berkshire Hathaway report ( recent article here) Warren Buffett said “The risks of being out of the game [market] are huge compared to the risks of being in it”

So, markets and share prices are volatile - for the day trader, this is where the action is, however as a total contrast, dividends are the sleepy backwater of the stockmarket, a positive oasis of calm. With most of the higher yielding shares and particularly investment trusts in my portfolio, the dividends are paid out on a regular quarterly of half yearly basis. Every year they increase a little to keep pace with inflation - maybe a little ahead. Even through the financial storm of the past 5 years, most have managed to maintain progressive payments. I have therefore learnt am learning to pay little or no attention to market ‘noise’ and the ups and downs of the prices - my focus will be on dividends and their rate of increase - this is my strategy for coping with volatility - maybe it could be useful for others.

So, to return to the opening sentence, conventional wisdom says equities are more risky? Not in my book - so long as you can manage the risk and accept volatility. Keep it simple, stick to what you know. I know equities give me a better return than cash - they give me a better return than gilts and the rising dividends provide a hedge against inflation. Thats not to say all my portfolio is invested in equities, its actually around 60% and in my next article, I will cover the important area of asset allocation.

In the meantime, over to you…. let me and other reader know how you deal with volatility.

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