What to make of recent market volatility?
In Compound Wealth’s June update I wrote about how volatility could be a friend to the long-term investor, by providing the opportunity to add to investments when prices are lower (Dollar Cost Averaging). October has provided an interesting test to this, with global share markets finishing October down 6.5% on average (albeit only partly offsetting a 16% rise over the previous 12 months).
As we would expect, for most investors the outcome has been much smoother than this. This is due our investment partners strategic approach to managing risk, which includes:
Diversification across asset classes, particularly holding some fixed interest investments in all but high growth-oriented portfolios, to smooth some of the variability in share returns.
Leaving 40% of global share investments deliberately “unhedged”, which means that any fall in the NZ Dollar would add to their value (as often happens during more significant market stress)
Over the past year, starting to invest into solid income generating businesses through the Booster “Tahi” fund, which are not listed on share markets and less affected by short-term market sentiment.
It’s worth highlighting that as a result, all diversified client portfolios have still delivered a positive return for the past six and twelve months, even taking into account the recent volatility.
“Corrections” are not unusual
The reality is that “healthy” market corrections are much more common than significant declines, such as the global financial crisis - which are usually driven by a large shock to the economic system. In contrast, corrections can typically be the result of short-term sentiment driven by fear or the news of the season. For a time, this tends to overshadow the longer term, more stable economic environment.
In fact, long-run performance suggests that investors should typically expect at least a 5% drop in share markets at some point every year, and a 10% fall every other year. Because of growth in the rest of the year, this hasn’t stopped 75% of the past 70 years delivering a positive outcome for share markets – and 90% of all 5 year periods. This is the long-run potential that share investments provide.
What happens after market corrections?
A typical “correction” is not the end of the world – far from it, as long as the economy is stable, and valuations are not unreasonably high. In those cases where fundamentals have continued to support an overall rising market, the average return in the year following a correction has been a strong 24%.
Discipline is key
This simply illustrates that just because markets have fallen, does not normally mean they will continue going down. Indeed, such an environment can be very healthy for stock markets as valuations become more supportive.
Within portfolios, it focuses our attention on the sustainability of the key drivers of market returns in recent years. Our analysis suggests these are still intact, although we continue to closely monitor the outlook for any meaningful changes. For investors in general, it reinforces the need to follow a disciplined investment plan, as volatility can indeed be a friend to the long-term investor.
If you have any questions please feel free to email me at adam@compoundwealth.co.nz