Are markets interesting, challenging, volatile, surprising or confusing?

2016 has been an interesting year thus far. With the S&P 500 index trading near its all-time high and up approximately 4% for the year-to-date at time of writing, one would be forgiven for thinking that the environment for risk assets has been somewhat easy going.

Following a sharp drawdown of approximately 10% and a spike in volatility that ended in mid-February, the S&P 500 rallied almost 17% to its current level.

This also happened at a time when developed market bond yields continued to decline and subsequently reached all-time lows.

This is not to mention the worries of the European banking system, the surprise Leave vote following the EU referendum in the UK, a disappointing corporate earnings environment and renewed global political risks.

So in fact 2016 has been anything but plain-sailing and to call the current environment interesting may sound a little strange.

Challenging, volatile, surprising and confusing may be more appropriate adjectives. But what has indeed been interesting are the actions and responses of investors that have bemoaned the return of volatility, showing that investors have once again failed to plan adequately for difficult times. Without adequate plans, investors often make poor decisions and it is these poor decisions that tend to amplify an already tricky environment.

Since global central banks have injected large amounts of liquidity into global asset markets, volatility has been artificially suppressed and drawdowns have been somewhat limited. Investors have therefore become accustomed to relatively shallow declines as markets have tended to behave themselves. It must be made clear that this by no means reflects the normal state of behaviour for risk assets. Recent bouts of volatility and drawdowns have led investors to believe that these movements are some sort of aberration. They are not. Volatility is very much a normal part of investing in equities and other risk assets, and is something investors should come to expect. It is also something that, when understood, may allow investors to become more self-aware and hopefully make better decisions – or at least make fewer bad decisions.

Volatility does not necessarily equal risk

As volatility tends to spike (rather rapidly) when asset prices fall, investors have become accustomed to associating volatility with risk.

As such, we cannot ignore the implications of using volatility as a risk measure but we can caution against its acceptance as the universal definition of risk. Rather, volatility is a type of risk. A more useful definition of risk may be the probability of losing capital or the probability of not achieving an investment goal.

These latter definitions may then be influenced by the impact of volatility. A rise in volatility may lead to an investor selling an investment at a price lower than its cost, resulting in the crystallisation of a loss. That is not to say investors should hold on to losing investments in order to avoid a certain loss, nor does it mean investors should be anchored to an arbitrary reference point, such as the cost price. Rather, it means investors may make the decision to sell an investment during a period of short-term volatility as a result of some emotional bias or response, without due regard for the longer-term attractiveness of the investment based on its underlying fundamentals. Volatility may also increase the probability of an investor not meeting their investment goal over the short-term. For a longer-term investor however, the impact should be somewhat less concerning.

Volatility has strong behavioural implications for investors, as behavioural biases are often exacerbated by market volatility. A recent note from Barclays summed this up nicely; during such periods of market stress, investors react in a way that prices in their rational current and future expectations of risk, but also the irrational and emotional anxiety of investors that may fear the worst. Short-term volatility is largely a consequence of investors’ responses to certain events, rather than as a result of changes in underlying fundamentals. These emotional responses paradoxically reinforce the market’s movements, but for those with a long-term investment horizon, such short-term episodes should not be overly consequential to their decision-making.

The need for an investment strategy

An investment strategy may take many forms or definitions but in essence it is designed to provide investors with a framework for investing their capital in a manner that gives them the greatest probability of achieving their investment goals. Given that this framework may implicitly or explicitly incorporate a set of rules or behavioural procedures, it is particularly beneficial to an investor when markets are volatile: when markets are behaving badly, the decision about what to do has already been made. Having a well-defined and constructed investment strategy is crucial in dealing with volatility. Without one, investors are prone to making sub-optimal decisions as a result of the impact volatility has on an investor’s emotional state. The strategy may well seek out opportunities in volatile conditions but at the very least, it should serve as a set of rules that prevents an investor from acting in a manner that may satisfy a short-term emotional need but may jeopardise the investor’s longer-term investment goals.

Where does this leave investors now?

It is difficult to get excited about equities at present when the asymmetry seems particularly skewed to the downside. The current market environment is one of benign economic growth, elevated equity valuations and poor corporate earnings growth. This also comes at a time when the diversification benefit of owning both bonds and equities is relatively poor, given that both asset classes are at trading near all-time highs. This makes the outlook for various asset classes somewhat more challenging. A more volatile market may well follow.

Regardless of the market’s behaviour going forward, investors should fully understand their investment strategy and how volatility is likely to impact their portfolios. Knee-jerk reactions, however right they feel, rarely produce consistent results that benefit the investor. This is unlikely to change. Investors prefer consistency to volatility yet those without a properly designed strategy continue to make decisions contrary to their stated desires and goals. Don’t expect this to change either.

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