This is a guest post by Robert Davies of Maven Capital Partners. Rob manages a passive “smart dividend” fund which tracks an index weighted on the size of a company’s dividend payments rather than its market cap.
One reason so many investors dislike equities is the volatility that accompanies them.
Most investors can remember the crash of 2008 when markets fell 50%, many will recall the plunge of 2001 in the wake of the dot come bubble bursting and then 9/11. There are even a few still around who lived through the 1987 storm.
These dramatic swings in valuations are unnerving. It makes people doubt the security of their investments and pushes them instead to the apparent safety of cash and fixed income.
The downside of that of course is that over the long-term those asset classes do not offer such high returns.
Volatility is the price that equity investors must pay to get better returns. It goes with the territory but it’s often a price worth paying for those who are able to take a long-term view and tuck capital away.
Investors are being lulled into a false sense of security by low volatility
Right now volatility is low. Not just in terms of months, or even years, but in decades.
The most well-known measure of volatility is the VIX index on the Chicago Options Exchange. Its current level of 10.5 is the lowest since the mid-nineties and is in stark contrast to the levels of 30 or 40 experienced a few years ago let alone the peak of nearly 90 attained in 2008.
This low level of volatility may tempt new investors into the equity market and that would be a good thing. However, they are misguided if they think this stability will continue, because it won’t.
Something will happen to destabilise the current equilibrium and markets will oscillate as they always have done, and possibly dramatically so.
In fact it is surprising that markets have been so stable in the face of tensions in the Ukraine, the China Sea and the lacklustre performance of so many Western economies. One reason for this can be summed up in the old saw that says “Don’t fight the Fed”.
Ever since the global financial crisis burst, US Federal Reserve has been creating conditions to alleviate the worst of the drama. It has been joined in that task by the Bank of England, the European Central Bank, the Bank of Japan and the People’s Bank of China.
With so many entities wanting economies to do better, and facilitating it by printing money on an previously unimagined scale, it is not surprising that equity markets have made upward progress. And they have done so in a remarkably smooth manner.
Some distortions have occurred, perhaps most notably in London property, but overall conditions seem exceedingly benign.
It won’t last of course.
Eventually some event will occur that will overwhelm the central banks, or take them by surprise. When it does volatility will return to markets, and probably with a vengeance.
Preparing for the return of volatility
That will be when investors suddenly start taking an interest in two measures of a fund’s performance that rarely attract attention.
One is the fund’s standard deviation and the other is its maximum drawdown.
The first simply measures how monthly returns over a given period vary around the average monthly performance. The lower the score the smoother the monthly returns are. It is an indication of how good the suspension is at smoothing out the bumps.
The other measure shows the largest decline in the value of a fund from peak to trough, and can be measured over different timeframes.
In effect it quantifies the biggest loss an investor could have made by entering and exiting the investment at the worst possible time in that particular period.
Another way of thinking about it is as an indication of how much support the stocks in a fund might have from fundamental measures like dividend yield and the price earnings ratio.
If a fund is full of racy growth companies with low yields and high valuations it is likely to fall further than one that has a bias to boring shares that offer good yields.
No one knows when volatility will return to the market, but it will. And like any house owner, the time to prepare for bad weather is when the sun is shining, so the time to prepare for high volatility markets is when volatility is low.
John Kingham says
I think Rob makes an interesting point with this article. When volatility is low over a prolonged period many investors, especially new investors, will extrapolate that into the future and assume that the future will be an easy upward ride with little risk.
It’s important to always remember how ugly things can get, especially after everything has been smooth and easy. In terms of the FTSE 100, think 2000-2003 after the generally smooth period of 1980-1998 and 2007-2008 after the mostly sunny days of 2003-2007.
One point to make is that I think Rob’s talking about the US market and the S&P 500 in particular, which has had an exceptionally smooth ride upwards after breaking into new highs in early 2013. Hopefully investors will remember that low volatility and high valuations can be an explosively bad combination.
Ken Brennan says
So true , I am often surprised how quickly investors forget. I recall that the Coppock indicator is such a measure or how long it takes to forget a painful event – a 14 month exponentially smoothed average !
Remember too 72-73 (I was at school) the drop was awful and widespread. Oddly 87 was an opportunity and warning. It did not feel like it at the time though but then they never do. One is disoriented by whats happening.
I like value investing or trying to buy a pounds worth of assets for 70P but I do have one eye on the market ( as I believe you do John ?). At the moment I have also been giving thought to what would I sell if I believe that the general market is going to drift down outside of its usual fluctuation. Best not be there , some reduction of ones exposure is a good idea however I never get that totally right.
John Kingham says
You’re right Ken, market timing based on valuations is notoriously difficult. I definitely keep both eyes on the overall market though and with a 3.5% yield from the FTSE 100 there aren’t any obvious dangers of a major decline any time soon. But you can never say never.