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Volatility – it can be an opportunity

Nine of March’s trading days recorded the biggest one-day gains and losses since the Second World War. Historically, times of crisis have been exceptional buying opportunities. Whether volatility is friend or foe depends on your circumstances and appetite for risk.

 

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Equity markets have been hitting the headlines for all the wrong reasons. After a long 11-year bull market, fear of the Covid-19 virus’s economic impact has triggered hysterical swings in prices. By late March, nine of the month’s trading days had reportedly gone on record as the biggest one-day gains and losses since the Second World War.

Despair and fear drove the markets, just as euphoria and greed had for most of the previous eleven years. The arcane field of behavioural finance, which studies how emotions often override logic in investing, shows that investors “herd” together at times like this. That means they follow each other – tending to all buy or all sell at once. The result is high volatility; in other words, violent movements in prices. 

Below are some critical aspects to consider when deciding if volatility is to your benefit or disadvantage.

Friend of foe? Friend!

1) Policymakers can counter volatility spikes
At times of market turmoil, all eyes are on policymakers. In a first move, they tend to cut interest rates decisively. Then, policymakers may make use of new policy tools, including liquidity injections, balance sheet extensions and fiscal measures such as government spending, tax credits etc. In the past, policymakers’ actions have proved very effective in moving markets to calmer waters over time.

2) Volatile markets can be a good time to invest
Known as the ‘fear gauge’, the VIX index measures the 30-day expected volatility of the S&P 500 index of leading US equities. Counterintuitively, when the VIX is very high – defined as above 40 versus a long-term average of 19 – the S&P 500 index’s average return for the next 12 months has been 14%, which is far higher than the long run average for US equities of 6% to 8%. Importantly, on 80% of occasions the S&P 500 index’s return would have been positive.

3) Cash can be a bad place to be
It’s said that to make money in the market you need to be invested in the market. Missing out on the five best days in the S&P 500 index since January 1992 would have been a substantial lost opportunity. An initial investment of USD 100 would have risen to ‘just’ USD 380 over the following 28 years, compared with USD 600. What a difference five days can make. Our analysis shows that the best days on equity markets tend to be the days when they bounce back from big falls at times of severe volatility.

Friend of foe? Foe!

1) The speed of recovery depends on government actions
While the weight of history suggests that government action will lead to a recovery in economic growth, there are no guarantees as to its timing or strength. Huge shocks such as the one economies are currently suffering can take years to repair. Even as governments act decisively, much uncertainty tends to remain. Have governments done enough? Will deflation follow? Will inflation follow? Has enough been done for economies to recover vigorously and asset prices to rise? 

2) Volatile markets hurt investors with short-term horizons
Often whether volatility is friend or foe depends on your time horizon. If you are close to retirement and in need of an investment income, volatility is most likely your foe. After all, if equity markets fall by a third and dividend income shrinks that leaves you considerably poorer. If, on the other hand, you do not need to cash in your investment for some years, a generational buying opportunity may beckon.

3) Balanced portfolios can be a better place to be
While it’s true that missing out on the equity market’s best days diminish returns, it’s also a fact that being fully invested during the market’s worst days has a similar effect. For the risk averse, a balanced portfolio of equities and bonds can smooth out the ups and downs.

Turning to today, will volatility prove your friend or foe? Policymakers could scarcely have been more active. In the US alone, the new stimulus package is worth USD 2 trillion or a stunning 9.5% of GDP, delivering huge economic support. What’s more, the VIX ‘fear’ index spiked up to extremely high levels above 80 in mid-March, before settling back at around 60, which may herald a strong return for equities over twelve months.

But judging whether to go against the herd and invest depends on your view and circumstances. If you have faith in the actions of policymakers, and the time and risk appetite to wait several years, then volatility could prove a good friend indeed.