Navigating volatility

When it comes to the potential for healthy long term returns, ‘growth’ assets like shares fit the bill. Not only can you expect to earn ongoing income such as dividends on shares, growth investments also offer the potential for capital growth.

The downside is that growth assets also come with higher risk. Capital gains in particular are by no means guaranteed. There will be periods when the market streaks ahead, making it rewarding and exciting to see the value of your investment climb – sometimes daily in the case of shares. However, there will be periods when markets dip. And that’s when our own behaviour can work against us.

We like to find 'cause and effect'

There is nothing new about ‘volatility’ – the way investment markets can go through periods of highs and lows. Graph 1 illustrates how the Australian sharemarket market regularly goes up, then down, then up again. What matters though is that the long term trend is upwards.

Nonetheless, the hard part can be deciding how you will handle volatility.

Graph 1 Historical performance of the ASX 200 Index

Source: as at 30 April 2019

The ASX 200 Index measures the performance of the largest 200 companies by market value. Data has been re-based at 100.

The narrative fallacy

As humans, we tend to look for reasons about why things happen. When unexpected or unpleasant events occur, we look for cause and effect.

This can make it easy to fall for the ‘narrative fallacy’. This describes how we all love a good story even though it can cloud our ability to make rational decisions based on information that we have evaluated objectively.

When sharemarkets fall we often turn to news reports for answers, looking for predictions on what will happen next. Our preference for a good story means we can choose the course of action with the less desirable outcome. If share values dip for instance, we may be tempted to sell out based on pessimistic media reports.

The reality however is that sharemarket movements, both up and down, cannot be explained by a simple story. Across the globe, billions of shares are bought and sold each day.  The sheer quantity involved means there are hundreds, perhaps thousands, of reasons why these stocks are traded.

How volatility can impact your returns

The fact is, sharemarkets are constantly shifting. This means that a loss in one month can be compensated for with a gain the next. By way of example, Australian shares recorded a 2018 calendar year loss of 6.9% (after allowing for dividends, this was reduced to 2.84%[1]). By contrast, the local sharemarket has enjoyed a 2019 year-to-date gain of 12.6%[2].

Looking at longer term results, as at the end of April 2019 Australian shares have recorded average annual returns of 6.58% annually over the last three years, and 5.58% annually over the last ten years[3].

These results demonstrate how the highs and lows even out, usually to deliver consistently higher long term returns than many other assets. Bear in mind too, the above figures do not include dividends.

Ways to navigate volatility

As an investor, news of a sharemarket fall can feel like the start of a game of ‘chicken’. How long will you hold your nerve before selling out?

If you’re rattled by news reports or the comments of those around you, bear in mind that these stories could be negatively impacting the way you behave as an investor. There may be no need to take any action at all if your investments continue to suit your goals and circumstances.

Risk and volatility can be managed. One strategy is to build a diverse investment portfolio. Spreading your money across a variety of assets helps to cushion you from the worst of the losses in any one market.

Taking a long term view helps too. Yes, shares go through highs and lows, but it’s worth reinforcing that as Graph 1 shows, the long term trend is upwards. This is clear evidence, not just a good story.

If you’re finding it hard to manage risk and volatility, speak with your Mortgage Choice Financial Adviser for more strategies on weathering market movements.

[1] as at 30 April 2019

[2] as at 30 April 2019

[3] as at 30 April 2019

Posted in: Investment loans