Volatility: How to be ready for the unexpected
Almost every asset type experiences some level of volatility in its price over time. Lower-volatility assets may generally fluctuate to a lesser degree than higher-volatility assets, but the unpredictability of global financial markets means investors should always been prepared for bouts of volatility.
Frequently, the drivers of market volatility cannot be predicted by even the most seasoned investor. Consider, for example, a natural disaster like the earthquake to hit Christchurch, New Zealand in 2011. It was, of course, a catastrophic human disaster, but it also had an economic impact, as described in the video below:
Staying invested over the long term
So how do investors prepare for the unpredictable? The first key point is to maintain a long-term focus. There is a saying in investing that time in the market beats timing the market.
It is notoriously difficult to time the market, especially in the case of unexpected, market-moving events like the Christchurch earthquake. An investor who dips in and out of the market to try to catch the highs and miss the lows is highly unlikely to be successful. Instead, investors should aim to stay invested for a meaningful length of time and ride out the ups and downs in pursuit of their ultimate goals.
Focusing on the fundamentals
The second point is to resist the pull of the human behavioural forces - like panic and greed – which, on the face of it, can make rational financial decisions very difficult.
‘Loss aversion’ describes the behavioural bias that could cause investors to miss out on attractive opportunities because of fear. A highly regarded study, led by mathematical psychologist Amos Tversky and Nobel Prize winner Daniel Kahneman, found that investors feel the pain of a loss twice as much as the joy of an equivalent gain.1
In investing, it is far more useful to focus on the fundamentals, not emotions. Invest only in the assets you consider a sound, long-term investment. Then, in periods of volatility, revisit the thesis to ensure the long-term prospects of the investment remain positive, once the short-term turbulence has passed.
It is helpful to remember that there are always plenty of different things going on in the world that can affect investment prospects. So, when we see markets being driven by just a single event, it is often reasonable to conclude that the impact of the event is likely being over-weighted.
Considering the earthquake example again, while it was a devastating event for the people of Christchurch and had a very real impact on the local economy, only certain sectors were directly impacted; meanwhile, in other regions and countries, the genuine economic impact was minimal. In the long term, even New Zealand’s economy was ultimately fairly resilient.
What this means is that when we see broad-based volatility across global markets, we should ask whether the catalyst really presents a long-term threat to investments in regions, sectors and companies away from the ‘epicentre’ – not just of an earthquake, but of any single event. This kind of short-term contagion can offer opportunities to invest in assets we already like on a fundamental basis, at a more attractive price.
- Loss aversion, Behavioral Economics