Why volatility is your friend

The JSE's wild start to the year shouldn't alarm long term investors.

Cape Town - Since the start of 2014 the JSE has bucked like a rodeo bull, and the investors riding on its back would be excused for feeling a little queasy.

The tone was set on the first few days of trading when the bourse rose to a record high of 46 836 on day one, and then almost immediately dipped by over 1 000 points in the next week. It then took off again to set another record on 23 January of 47 348, only to start an even more spectacular plummet that took it as low as 44 145 in just eight days of consecutive losses.

For many investors in equity unit trusts, this kind of volatility is a scary thing. They see the these swings on the JSE and wonder about how safe their money is.

This is a fair response, because most of us are tuned to value consistency. When we buy a car, for instance, most of us prefer one that is going to perform in a predictable way. Even if a vehicle bolts like a Ferrari one day, it's not much good if it is only going to choke and splutter and barely get out of the driveway the next.

But the tricky thing for many investors, particularly those who are new to the market, is that stock markets don't work like that. Not in the short term anyway.

When looking at their performance in terms of days, weeks and sometimes even months, the peaks and troughs can seem huge. And particularly when one is actually experiencing them, they can appear frightening.

But investing in equity unit trusts is not about those shorter periods. It is about taking a further step back and looking at how markets perform over periods of five years, ten years and even longer. What emerges then is a very different picture.

Because the sort of volatility that the JSE has seen at the start of this year is not unique. We have seen its like, and even worse, before. And when one takes a longer term view of the performance of the JSE, one sees that these short term ups and downs are less obvious than what is actually a consistent long-term trend of gains.

It is the most boring lesson in equity investing, but it is also the most important: staying invested for the long term is far more important that worrying about what is happening day to day.

“Without wanting to be insolent, we do not concern ourselves with volatility at all as it has little bearing on investors long term returns,” explains Ricco Friedrich of SIM Unconstrained Capital Partners. “The reason is that we don’t see volatility as 'risk'. In the world of investing, risk comes down to a permanent loss of capital or your money not growing at least with inflation. Volatility does not even come into the equation.”

He emphasises that at times like this investors need to keep their goals in mind, and for most people in equity unit trusts that means thinking well into the future.

“All investors, including those hitting retirement at age 60, should be thinking in the long term rather than focused on the next year of returns,” Friedrich says. “Most investors are however fixated on short term fluctuations.

“And in a short term world, the probability of making a loss on a rolling 12 month basis is quite high. However, if you have a five year view (which is still short when one is saving for your retirement), the probability of loss is significantly reduced.”

The below chart illustrates his point. On a rolling five year basis, there have been very few periods when returns on the JSE have been negative, and even when this has happened it has never been sustained for very long.

Source: I-Net Bridge

 

While the lesson here is quite obvious, there is also a more subtle reason for not running for the exits at the first sign of a downturn.

“Increased volatility tends to be associated with down markets which is why investors may panic,” Friedrich says. “But volatility actually creates opportunities for investors with patience.”

This is exemplified by the attitude of Dave Foord, the Chief Investment Officer at Foord Asset Management.

“We love short term volatility,” he says. “It presents an opportunity to buy or sell at unusual prices.”

What that means is that when the market overshoots, fund managers can sell shares that they believe have become over-priced, or when the market falls it may be a chance to buy shares that they see as now under-priced. Being able to do this is ultimately how the best fund managers beat the market over the long term.

“Prices may fluctuate wildly in the short term compared to a far more stable assessment of the fair value of a company,” explains Friedrich. “Short term volatility is driven largely by investor sentiment which may create great opportunities for investors like us with a long term time horizon. In the short term sentiment drives share prices; however in the long term valuation ultimately trumps sentiment. That's why volatility is our friend.”

Roger Williams, manager of the Centaur MET Flexible Fund, takes this point further.

“We invest with a multi-year time horizon and short-term volatility does not affect this strategy, but tactically in a high volatility environment we will try to execute trades at better prices,” he says. “So short-term volatility is actually beneficial as it enables one to gain some level of out-performance by better execution.”

Mark Cliff, the Head of Marketing at PSG Asset Management, suggests that anyone invested in funds that hold equities should be able to tolerate volatility.

“Existing investors need to ride out the storm,” he says. “At the same time, anyone eyeing equity-type investments now should appreciate that many of the stocks in these funds are now cheaper than they were a little while ago and are also trading on lower price-to-earnings multiples. That should be enticing to long-term investors.”

This point is picked up on by senior portfolio manager at Coronation Asset Management Neville Chester:

“Typically, short term volatility offers long term investors opportunities to build positions in investments they like, or sell out of one’s which have gotten expensive,” he says. “As difficult as it is at that point in time, a volatile market often does offer up opportunities for those investors prepared to stomach the volatility and take a longer term view.”

So while this kind of volatility can seem shocking, the most important thing for any investor in unit trusts is not to follow the herd mentality and panic. Every year, people lose significant amounts of money by responding to short term market movements and selling or buying based on headlines.

​But investors who are committed to their long term investment goals and are aligned to the unit trusts they have chosen to get them there can take a more philosophical view of these sharp ups and downs. They are the ones who will stay invested, benefit the most from the moves their fund managers can make in this environment, and earn the best long term results.