So long as investors are comfortable with the idea of 'getting rich slowly', writes John Husselbee, they can ride out short-term falls on the path to long-term gains
After a tumultuous end to 2018 and more of the same so far this year, no investor will need to be told that volatility is firmly back on the agenda. It is never the easiest metric to pin down, but one common measure is the so-called ‘Fear Index' in the US - known formally as the Vix - which gives an indication of equity market volatility going back as far as 1990.
Just two years ago saw a period of all-time lows in this index - to give some context, it sat around the 10 mark versus a long-term average of 19.5 and a high, in October 2008, above 80 - but, following recent events, the level is much closer to that average once again.
Reasons behind this recent spike hardly need repeating here but you can take your pick from fears over slowing growth, the well-worn trio of trade wars, Brexit and tightening monetary policy - or all of the above under the broad umbrella of ‘uncertainty'.
More important than discerning the exact reasons for this rise in volatility is the growing realisation elevated levels may be here to stay and the lower Vix readings of the last decade or so were the anomaly. As stated, a key factor here is the ongoing removal of volatility-dampening quantitative easing: just as pumping so much money into the global financial system was unprecedented, removing it - however gradually - also takes us into uncharted territory.
Cutting through all this, the key thing for investors to understand - at least, those prepared to take a longer-term approach - is that volatility can create opportunities, particularly for active managers. In the generally rising markets of the post-financial crisis period, passive funds have come to the fore and enjoyed huge inflows; in more volatile conditions however, where there will be greater performance disparity between stocks, active managers have greater capacity to prove their worth.
We are not anti-passive and use tracker products in our portfolios where we feel they can serve a purpose but the fact these funds cannot discern between companies and will fall with the market seems to have been forgotten in the heady days of the last decade.
So what should investors keep in mind in the face of higher volatility? The first thing to stress is that pullbacks of 5% to 10% have traditionally been a function of healthy markets. As things stand - despite the laundry list of factors outlined earlier - we still look some way away from genuine global recession.
Second is the fact that, while volatility can offer opportunities for patient investors, it can also worry others out of markets and lead to major losses. Some data on the FTSE 100 shows what can happen when investors sell out of markets based on panic: 26 of 35 calendar-year returns from the blue-chip index since launch in 1984 have been positive, with average performance around 11%. All those years saw drawdowns at certain points, however, with an average maximum loss of 14.5%.
If investors are comfortable with what we call ‘getting rich slowly', they can ride out short-term falls on the path to long-term gains. Positive years from the FTSE are three times more likely than bad ones but more anxious investors often sell on the back of drawdowns and risk, giving up substantial returns.
When it comes to equities, the key message is not to panic and stay on board - stocks and shares have clearly outperformed cash and inflation over the long term and form the bedrock of a well-diversified portfolio but there will be some volatility along the way.
Core argument for diversification
Volatility also reinforces the core argument for diversification, which remains a key but often misunderstood part of successful multi-asset investing. As Harry Markowitz once said, diversification is "the only free lunch in finance" and his Modern Portfolio Theory, developed in the 1950s, set the framework for building portfolios of assets that can maximise returns for a given level of risk.
Diversification should not be taken to mean aggressive shifts into and out of asset classes, however - asset allocators often talk about the freedom to zero-weight certain areas as a sign of an active approach but we feel this fundamentally misses the point. While it might be uncomfortable to hold a falling asset, something else is likely to be rising at the same time and it is the overall blend that helps produce a smoother performance ride over the long term. Zero weighting is not diversification.
We have always stressed the fact every asset class has its day in the sun and recent months have seen rotations across not just assets but sectors, stocks and styles as well. Ultimately, the same asset rarely tops performance charts year in, year out - within equities, these changes in fortune are even more pronounced and first-to-worst transitions in terms of markets are fairly common within the space of 12 months.
John Husselbee is head of multi-asset at Liontrust
This article first appeared in the new issue of Professional Adviser's sister title Multi-Asset Review, which is now out. To make sure you receive your own copy of the next issue, please do register your interest here
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