Volatility is not your enemy

By Phillip Mjoli, Segment Head: Institutional Business

“Volatility is not the enemy of the long-term investor. The investor’s response to it is.” Josh Brown (author of Backstage Wallstreet)

When asked what the stock market would do, JP Morgan once remarked: “it will fluctuate”. It was a safe prediction. No matter how well we manage our investments, the ups and downs in the markets will continue. Modern financial theory says that these ups and downs present greater opportunities for returns. All stocks will experience volatility at some point. Stocks fluctuate. So it goes.

The confusion between risk and volatility
Volatility is loosely defined as the tendency of the share price to fluctuate (go up and down) sharply. In financial theory, volatility is really just the extent to which an investment’s monthly returns deviate from their average on a month-to-month basis. There is an important difference between an investment’s volatility and its risk, and we should not be confused.  Often when people talk about volatility, they tend to confuse it with their fear of a permanent loss. An investment’s volatility should really only be a concern to investors if the money is needed in the immediate future. For a member of a retirement fund who has an investment horizon of more than ten years, this should not be a concern.

Of course, this will be different for members closer to retirement, where capital protection is important. Also remember that just because an investment is more volatile does not necessarily mean it is more risky in the long term. As we’ve seen historically, the longer your investment time horizon, the less negative impact volatility will have. We have also seen that on average, over the past 80 years, it took 4 years for an investment to recover its original value after a major market dip. Once again, in the context of a long-term membership in a retirement fund, this is not a significant concern.

The only time volatility can cause permanent losses is when investors choose to sell after a sudden drop, thereby locking in their losses. Selling is the worst thing you can do in this instance. The problem is that people equate risk with volatility.

What is risk?

Academics define risk as the chance that you will lose some or all of the capital you invest, or the possibility that the actual return on your investment will be lower than you expected. If you are worried about the “risk level” of a certain investment, you are worried about the potential permanent loss of your money.

Over the long term, however, there is no direct relationship between risk of capital losses and volatility. In fact, if you are in for the long haul, volatility can even be your friend, enabling you to buy more of a share when it’s at a low ebb. The greatest risk you face as an individual investor is running out of money after you retire. Not achieving your goals is another huge risk you face. These are your real risks, not movements up or down in the markets.

Look at volatility as a source of opportunity, not something to be afraid of
When evaluating the substance of your retirement portfolio, don’t make the mistake of taking your foot off the gas pedal by winding down your exposure to equity. By focusing too much on volatility and thereby eliminating equity from your investment portfolio, you are intensifying the risk of not meeting your investment goals.

According to Barend Ritter at Sanlam Investments, as humans, we are programmed to avoid pain and prevent losses, because we experience the pain of loss twice as badly as the joy of gain. In our need to avoid pain, we invest too cautiously in equities because we prefer ‘smoother’ investment returns. When market volatility occurs, we see the losses in the market and panic. Human instinct takes over and we tend to sell because we want to prevent further losses. Unfortunately, in doing this, we lock in/actualise those losses. Ironically, we bring about the very pain/loss we sought so hard to avoid.

“The best action you can take during a market dip is to stay calm, stay the course and remain invested, riding out the market volatility from beginning to end.”

Key takeaways:

• Don’t let the short-term ups and downs in the markets hinder a critical long-term investment decision, such as retirement.
• Understand that volatility is inevitable, it is the mainstay of investing, and if your fund members have a long enough time horizon, you’ll be able to harness it for your own benefit.
• The best chance of not running out of money in retirement is to have a sensible and adequate participation in the equity (stock) market. Equities are volatile in the short-term, but over the past 80 years have proved to be the best performing asset class by far, essential for achieving long-term, inflation-beating returns for retirement fund members.
• Volatility can be your friend in the long term.