The financial markets were all over the place at the beginning of 2020. Prices declined sharply, recovered, then dropped again. It’s called volatility, and it can make those suffering from weak stomachs feel deeply uneasy.
In such an environment, it seems then almost discordant that we talk about opportunities, sometimes even encouraging some of you to add to your portfolio.
Close to the worst drop, journalist Neil Irwin published a thoughtful article in The New York Times1 about falling and volatile markets, which gives an insight into what we mean.
Mr. Irwin wrote: “When the stock market falls as far and as fast as it has in the last three weeks, it is perfectly natural to be terrified. It requires a leap of faith just to place hard-won savings in such an abstract, ephemeral thing as a share of stock or an exchange-traded fund. Instead of spending on something concrete that can be enjoyed immediately (…).”
Although Mr. Irwin’s commentary was about falling markets, his underlying observations could be applied equally to markets that fall, rise, fall again, only to re-emerge – yo-yo like – on the rebound:
- We all have primal fears about sudden losses and apparently irrational gains.
- But volatility is natural to the financial markets. Most often you can benefit from it by staying invested.
When optimism shifts to fear
We’ve made these observations in the past:
- Earnings tend to rise over time, as the world economy grows.
- The price we pay to get a slice of those earnings can swing wildly.
- When accumulated assets decline in value suddenly, optimism shifts to fear.
- Fear precipitates biases and massive selling.
Wrote Mr. Irwin: “The moments when sentiment shifts from optimism to fear are scary when you have an accumulated pile of savings declining in value. But it also means that the value you’re getting on any future earnings has increased.”
Let’s get technical for a moment. There’s something out there called equity risk premium, which can be defined – perhaps a shade simplistically – as the extra return that investors expect to receive in the long run by investing in a diversified basket of stocks.
Wrote Kerry Pechter in Forbes2: “On average, since the Great Depression, stocks have delivered an attractive average (or equity) risk premium. That’s why people buy them and hold them for a long time, even though stocks are riskier (more prone to price fluctuations in the short run) than bonds.”
In short, you get higher long-term returns as compensation for tolerating volatility.
As Mr. Irwin states: “The fact that stocks are extraordinarily volatile right now, in that sense, isn’t a problem with stock investing – it’s a feature!”
Most importantly, experienced Portfolio Managers will tune their strategy to keep the risk at a tolerable level by diversifying asset classes and by carefully selecting each investment. Remember that building a good portfolio requires much more than shopping for low prices on stocks that performed well in the past. In future blogs we will talk in detail about how intricate this process is.
But one thing is sure: there are opportunities in volatile times. So, when markets yo-yo, take the opportunity to profit from them by staying invested and continuing to think long-term.