Market Volatility In Perspective
Firstly, what is a “bull” and what is a “bear”?
As a nice simple analogy, bulls toss things into the air with their horns, while bears drag their prey down. So, one can deduce that a bull market is one that is expected to go UP and a bear market is expected to go DOWN.
Although no one can reliably predict the timing of bear markets or bull markets, a prudent investor should understand that equity prices can decline and be prepared to “ride out” these periods when they occur. The big danger from bear markets is that an investor will sell at or near the bottom of the downturn. Unfortunately, much of the material presented in the press is often there to try and “talk” a market up (create a bull market) when, in fact, a bear market is looming on the horizon. As bear markets are more traumatic to us simple folk, let’s have a look at them specifically.
What constitutes a bear market?
A major market downturn is known as a “bear market”. Bear markets (regarded to be a decline of 20% or more in a market and lasting for longer than 3 months) and which can occur both in stocks and bonds, can be trying for even the most seasoned investor.
Bear markets are part of investing – over the past 45 years, nine downturns are generally regarded to have been bear markets. Bear markets have on average occurred once almost every 5 years. The average duration was 12 months, with the shortest being 3 months and the longest 21 months. It has taken on average almost 19 months for equity levels to return to the levels achieved before the market downturns.
Market volatility – what are its effects?
Over the long-term (1926 -1999) returns from equities averaged 11.3%, but this return masks a great deal of volatility. In the 74 years from 1926-2000, the market provided annual returns ranging from a low of around 43% (1931) to a high of 54.2% (1933).
This extreme volatility is the main risk of investing in equities, however it is this risk which tends to recede from investors’ memories after a lengthy period of rising share prices, such as the period in the US that began in August 1982 and ended well into 2000 – (the bear markets of 1987 and 1990 were short-lived, in fact in 1987 stocks actually provided positive returns).
Should you sell in a bear market?
After sharp downturns in the market, the idea of selling out of your holdings and sitting on the sidelines until the markets are calmer is alluring, but rarely successful. Financial markets don’t move in predictable patterns and there is no sure-fire system to profit from “timing” these movements. To profit from market timing, an investor will need to be right twice i.e. once in choosing when to sell, and once in choosing when to buy. To succeed, you must be right often enough to overcome any transaction costs and taxes (e.g. Capital Gains Tax). Few investors have succeeded in getting it right, regularly, for long periods of time.
What can reduce volatility?
(1) Focus on time, not timing
Your time horizon (the length of time until you expect to need money from an investment) should be the first consideration. Focus on the time period you are investing over, not on timing the markets.
(2) Time tames volatility
Research has shown that the longer investors stay in the market, the smaller the likelihood that they will lose money, and the greater the chance they will make money.
(3) Invest for the long-term
Although it is not easy when the markets are sky-rocketing or plunging, try to maintain a long-term focus. Markets are subject to both manic highs (e.g. NASDAQ) and depressive lows (e.g. Russian debt default). History has shown that by riding out the inevitable bear markets in equities (and avoiding the temptation to sell when prices are down and sentiment is gloomy) you should enhance your chance of achieving solid, long-term returns.
(4) Build a balanced portfolio
Although you cannot escape volatility, you can moderate it by investing in a mix of assets (equities, bonds and cash). Holding a balanced portfolio means you may not earn the peak return from any one asset class, but you also won’t have all your eggs in the basket that takes the biggest fall.
Although no one can reliably predict the timing of bear markets (or bull markets), an investor should understand that markets are notoriously fickle. Once you decide on an investment program that suits your needs and financial situation, commit to your plan and remain focused on the long-term. However, periodically revisit your investment portfolio and make adjustments, if necessary, to your mix of assets so as to keep in line with your long-term goals.
The markets may or may not be in for more rough sailing in the immediate future, but a prudent investor is always prepared. During the 1990’s, the US stock market provided investors with an average annual return of 18.2% *, outpacing the long-term historical average of 11% (1926-2000) *. By the end of the 1990’s, the market had not suffered a severe or prolonged period of falling prices in quite some time. This period of good fortune changed in 2000.
This document is supplied by Brantam Financial Services Ltd and is published for the information only and is not to be taken as constituting advice or recommendations, in relation to investments held investors. Whilst every effort has been made to ensure accuracy of the information provided in this document, no responsibility will be accepted for action taken in reliance on it.