Keep your head in times of volatility

Fears are growing over the Fed’s interest rate decision due to the knock-on effects for the rest of the world. Over the past few years, emerging market companies took advantage of these ultra-low rates and increased borrowing levels to the extent that balance sheet debt now significantly exceeds market capitalisation.

However, the largest contribution to volatility came in August when China devalued its currency and sent shockwaves through global markets. Volatility signals (orange indicator shown below) broke through the two standard deviation levels (green lines) for the first time in two years.

The chart below also shows that the largest market gyrations over the past 10 years occurred in October 2008 during the financial crisis. And as an investor, you should be prepared for more volatility going forward as many global economies are struggling to grow, and market valuations are at elevated levels.

Investors are often not positioned appropriately, and end up with suboptimal results during times like this. A key consideration lies in understanding your risk tolerance along with your ability to withstand shorter-term losses. Equally important, you also need to have a good understanding of the characteristics of the funds in which you are investing. To generate inflation beating returns over the long term, investors must take a balanced approach to risk. Being too conservative is detrimental to long-term wealth creation due to the effect of inflation eroding the real value of your capital. Portfolio construction therefore requires striking a delicate balance between risky assets that strongly outperform inflation over the long term versus more stable assets that don’t perform as well against inflation but are characterised by lower capital volatility.

The chart below illustrates the potential range of returns that can be expected over a one-year period by holding increasing proportions of equity in your portfolio with the rest in cash. As we will discuss in more detail below, despite the sometimes large losses that may occur when measured over a short timeframe, equities have been the best performing asset class by far over the long term.

Using the graph above as an example, a simple investment portfolio comprising of a 60% weighting to local equities and a 40% weighting to local cash has historically delivered returns between -31% and +33% over one year, while a portfolio that is 100% invested in local equities has delivered returns between -49% and +51% over the same period.

Over the past 100 years, equity markets have delivered a 7% return above inflation. Contrast this with the returns from cash of 1% above inflation. Equity returns don’t come smoothly, and although there have been some major market crashes along the way, investors do need an allocation to equities to grow wealth over time. As an investor, it is critical to understand the trade-offs between risk, return and time horizon when constructing your portfolio.

In addition, by diversifying your portfolio with complementary asset classes, you can successfully minimise capital losses and smooth out volatility of returns at the same time. Diversification adds value because asset classes behave differently under various market conditions.

Typical human emotional responses don’t usually result in great investment outcomes, which is why many investors end up buying when the market is high and selling low. In fact, research shows that the average investor suffers from poorly-timed decisions, resulting in returns that are lower by 6% per annum compared to a simple buy and hold strategy. Therefore, a reliable approach to achieving investment success is to maximise your time horizon. The table below is based on empirical data and shows your chances of suffering a loss of capital.

By extending your time horizon, you can significantly reduce your risk of making a loss. This principle works regardless of how much you hold in equities – the more difficult part is to withstand the shorter-term gyrations along the way without disinvesting.

Three steps that you can take to optimise your investment strategy

•  Educate yourself on financial markets, asset classes and key investment principles.
•  Develop a sound financial plan and focus on what you can control, for example:
  • your objectives
  • your time horizon to achieve your objective
  • the level of risk you need to accept
  • increasing your contribution
• Employ experts to assist in your decision-making.

Always keep the long-term perspective in mind when making decisions and only change your strategy if your objectives change. Set clear goals and create incentives to achieve them. Remember that the fundamental purpose of investing is to secure your future. To be successful, you need to follow a few important steps while keeping your emotions in check and in time, you will reap the rewards.