Fisher Investments UK

Understanding Volatility’s Role in Your Portfolio

Understanding Volatility’s Role in Your Portfolio
Text settings
Comments

It’s no secret many investors struggle with market volatility. But volatility can actually be your best friend. When many people think about volatility, they imagine stock market corrections and steep market declines.

In reality, volatility is a two-way street. Volatility to the upside is just as significant and helps drive stocks’ long-term rise. You probably like volatility when it’s to the upside (although you probably don’t think of it as “volatility”) and you probably hate the downside variety. Here’s another example. Many investors exclaim their disdain for equities after a downturn, but these same people have huge appetites for shares during a roaring bull market. This is classic myopic loss aversion—the tendency for investors to feel the pain from investment losses much more than they feel joy from gains. This often leads investors to try and protect themselves from future short-term losses and the pain those would cause. These investors aren’t necessarily risk-averse; they’re often just short-sighted and not fully aware of the risks they are taking. If you fear the volatility of equities, some cognitive coaching, staying focused on the long term, and planning for the most probabilistic outcomes might help you learn to tolerate or even love volatility. This might enable you to benefit more from the historic returns of equities.

It’s not easy to stay disciplined during periods of stock market volatility, and some investors just can’t handle the wiggles. Humans naturally think about near-term survival, which is good but may not help when navigating complex capital markets. However, if you can train yourself to think longer term, the “can’t sleep-at-night” factors tend to fade away. For long-term investors, an investment coach or adviser may be one of the best remedies to worry and a safeguard against potential investing errors that often accompany such emotions.

If you’re investing for the long term it can give you a different perspective on volatility. Whilst you may need to reduce volatility to achieve near-term goals, such as saving for a down payment on a home or building up a cash reserve to meet unexpected expenses, if you’re in it for the long haul volatility is not the enemy. Equities, more volatile in the short term, offer a much higher rate of return over the decades than fixed-interest securities. Let’s explore the long-term returns of the two asset classes and how they compare.

Since 1926, there have been 64 rolling 30-year periods. Equities have outperformed fixed interest each time and by an average margin of 4.8-to-1 in those periods.[i] Even over shorter, 20-year periods, probabilities still favour equities over fixed interest. Since 1926, equities have outpaced fixed interest in 67 of the 74 20-year rolling periods (91 percent of the time), by a 3.4-to-1 margin on average.[ii]

Despite this, some people still fear equity investing for the long term despite the high probability that equities will outperform fixed interest. Such investors may fear that this time, when they decide to invest, will be one of the few times equities are down big. However, in those rare 20-year periods when fixed interest beat equities, it was only by a 1.6-to-1 margin on average.[iii] So, even if you invested in fixed-interest in those periods, you didn’t outpace equities by a huge margin. During most of the other intervals equities have dramatically outperformed fixed interest. Said differently, it’s not very probable fixed interest outperforms equities over 20- or 30-year periods, and even when they do, it’s not by much.

Whilst the historical evidence is very strong, remember that investing isn’t about certainties. Instead, like medicine and other scientific fields, it’s about probabilities. Even though studying history can give you an idea of which outcomes might be the most probable, past performance doesn’t predict what will happen in the future. But, if you need to invest for 30+ years (as many investors do) and require long-term growth, the odds are in equities’ favour.

There will always be some investors who aren’t able to change their perspective from the near term. The volatility and sleeplessness are too much for them. This is fine too! But for these investors, they may have to lower their long-term return expectations. Or if they are not able to weather the volatility inherent in stocks, they may need to earn more money in other ways or spend less money to offset potentially lower long-term investment returns.

The simple truth of the risk/return tradeoff is you can’t get equity-like returns without equity-like volatility. Equities are risky in the short term and no place to store your next month’s rent or mortgage payment. But over longer periods of time, fixed interest investments may be risky, too, if your longer-term goals require growth. If you can learn to worry less, stay focused on the long term, and plan for the most likely rather than worst case possible outcomes, volatility can be your friend.

Interested in planning for your retirement? Get our ongoing insights, starting with your free copy of The 15-Minute Retirement Plan.

IN ASSOCIATION WITH

Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: 2nd Floor, 6-10 Whitfield Street, London, W1T 2RE, United Kingdom.

Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.

[i] Source: Global Financial Data (GFD), Inc., as of 05/06/2019. Equity and fixed-interest 30-year rolling annual returns measured by GFD’s Developed World Return Index and GFD’s 10-Year Government Bonds Index, respectively, 12/31/1925–12/31/2018. Presented in Great British pounds (GBP).

[ii] Source: Global Financial Data (GFD), Inc., as of 05/06/2019. Equity and fixed-interest 20-year rolling annual returns measured by GFD’s Developed World Return Index and GFD’s 10-Year Government Bonds Index, respectively, 12/31/1925–12/31/2018. Presented in Great British pounds (GBP).

[iii] Ibid.