How to… cope with volatility

Is volatility a friend or foe to the long-term investor? Chief investment officer Ian Brady discusses its impact on our ultimate investment goals.

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There is a lot of talk about volatility, maybe too much talk (sorry, Bono) in the financial press, but how much of a problem is it for the long-term investor and how can we mitigate its impact on our ultimate investment goals?

Five-year minimum timeframe

The first line of defence against volatility is setting an appropriate timeframe for the investment.  I strongly agree with the assertion that any investment that has a meaningful equity component should be for a minimum of five years.  This time period helps ensure investors are involved for the majority, if not all, of a full economic cycle and will thus mitigate the impact of ‘getting in at the peak’ just prior to a cyclical downturn.

“In the short term the stock market is a voting machine, in the long term it is a weighing machine”

Impact of time

The impact of time can be illustrated by a Morningstar report produced for the Growth Model of an award-winning wealth manager.  We chose the growth model as this is considered its most volatile offering since it has the highest equity weighting.  This illustration goes back ten years from today but the research has been undertaken since 2008 so the ten year back testing includes the Tech Boom and Bust, 9/11, the Enron bankruptcy, the Lehman Brothers collapse and the various Euro crises.  It has certainly not been a period for the faint of heart.

Managing loss

As one would expect for such a portfolio, the one year and even three-month drawdowns are quite large (and no doubt terrifying at the time).  While one would certainly not be uncorking the champagne to celebrate such three year returns, we need to put it in context.  This loss would only be borne by those unfortunate enough to invest in the very worst day possible over a fifteen year period and this period encompassed two of the worst post war financial crises on record.  Viewed in this light the loss is manageable and should not be lifestyle damaging.

Short-term losses or damaged business model

This brings me on to two other separate, but related, points because the portfolio in question has a quality bias in its investment criteria.  The first is having the acumen to distinguish between what is likely to be short-term losses due to market volatility and permanent loss of capital due to an irreparably damaged business model.

The second is having the discipline to primarily buy quality investment vehicles, whether they are in fashion or not.  This is not a growth-at-any-price strategy.  It is a risk mitigation strategy for long-term investors and reduces the chance that the losses we suffer are not permanent reductions in capital.  If we can consistently invest in companies which have good balance sheets, free cashflow and investor friendly managements then it is likely any losses we suffer are likely to be ephemeral, as over time the compounding effect of dividend increases will lead to capital gains.

Investments need not be confined to consumer staple companies but rather leading or niche companies across a wide spectrum of industries which are not price takers.

Friend or foe?

This enables us to address the issue of whether volatility is friend or foe.  If we can pick up quality investments be they equities, properties (or even bonds) when they are out of favour and selling at depressed valuation then we greatly increase the chance of outsized returns as valuations normalise.  The current era, where macro risks dominate the investment landscape, throws up many such opportunities as markets often sell almost all securities down simultaneously, causing correlations to rise both across and between asset classes.

A ‘weighing machine’

This volatility, therefore, enables those with a longer-term horizon to buy ‘quality at a discount’ without having to take on the increased risk of investing in weaker business models.  In a similar fashion volatility can work in our favour when investors become irrationally exuberant by enabling us to lock in profits in sections of the investment universe which have become grossly overvalued.  It should be noted however, that such volatility is likely to be you foe if you are marking your portfolio to a benchmark every month as it is notoriously difficult to call the exact peak or trough in a market trend.

But if your aim is to build absolute returns towards a specific long-term goal then a strategy which focuses on quality, avoids excessive valuation and makes a friend of short-term volatility is one which is most likely to enable your long-term financial dreams to be realised.

As Benjamin Graham put it: “In the short term the stock market is a voting machine, in the long term it is a weighing machine.”

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