Monday, August 17, 2020

An investor’s guide to surviving volatile markets

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As stocks worldwide take a beating after the coronavirus pandemic created the biggest economic uncertainty in decades, traders must remember that it pays to keep calm and stay invested.

It is often said there is more to be made in markets that are moving, than from those that are standing still. But once the rollercoaster starts, many investors jump right off and head for the exit - because making a profit in a volatile market is easier said than done.

As soon as it became apparent in March that COVID-19 would be a global pandemic with enormous economic impact, markets plummeted in all asset classes. And although the market turmoil has to some extent abated since, a large degree of uncertainty remains.

US stock market volatility, as measured by the Chicago Board Options Exchange’s Volatility Index (CBOE VIX), reached its highest levels in March; the highest since the pinnacle of the global financial crisis in October/November 2008. The VIX peaked at 82.69 on March 16th, at the height of the market’s alarm at the economic implications of the pandemic. The panic has subsided since, but volatility remains high. By late July, the VIX was trending around 27 points, still about 40% above its historic average.i This suggests investors remain uneasy about the market’s recovery and equity prices may stay bumpy for some time, particularly if economic and corporate results come in below expectations.

 

Source: Refinitiv

Stay invested for the long term

The first lesson when confronted by sudden volatility in markets is not to panic. Some investors fall prey to self-doubt, particularly as the media goes into overdrive reporting every new alarming number and prediction, but the headlines can be too heavily focused on the immediate implications of an event rather than looking at how things will pan out over the long term.

Unless an investor sells at the first sign of trouble and can move back in after prices have bottomed, cashing out in a panic can lead not just to substantial losses, but missing out when prices do pick up. It takes perfect timing to sell right at the peak of the market and then buy right at its bottom. In the real world, few will be so omniscient, or lucky, as to make a killing from such perfect timing. For those who sold out of their equity holdings and parked their holdings in cash, missing out on the initial upswing in a market recovery can cost dearly.

Investors in stock markets will find that holding out for the long term by staying invested will usually be the best strategy. It will also be likely that after the first flush of selling and portfolio realignments, assets seen as safe havens can soon become a lot more expensive than their fundamentals justify.

The performance of the Dow Jones Industrial Average across the past 30 years provides plenty of evidence for the strength of a ‘do nothing’ strategy. There were significant downturns in 1997 during the Asian crisis, in 2000 after the dot-com bubble, in 2001 after the 9/11 attacks, and in 2008 during the global financial crisis, but the market recovered each time and the long-term trend was reasserted.

Market crashes are an unfortunate fact of investing life so any long-term investor ought to expect one or two along the way, and what might seem like the end of the world at the time, inevitably isn’t. The 2020 COVID 19-led market crash has been as severe as the 2008 financial crisis, but the recovery so far is taking place at a much faster pace.

Source: Refinitiv

If an investor decides to stay invested in the market and ride it all out, one way is to commit to ‘dollar-cost averaging’, whereby a fixed amount of money is committed to be added at regular intervals to a particular investment. This can help reduce anxiety about staying invested when markets get rocky.

Reassess risk levels, review portfolio

Staying calm doesn’t necessarily entail staying still, however, and many investors will feel happier taking an active hand in their portfolio. Even though they may not want to cash out, investors may feel that now is the right time to review their portfolios and readjust their risk-on and risk-off weightings to match their risk appetites. They will also want to ensure their portfolios are diversified enough to spread the risk across different asset classes, thereby minimising the overall risk.

Diversifying asset weightings during periods of volatility will normally involve increasing weightings in traditional safe havens such as gold, the US dollar or fixed-income instruments such as US Treasuries, or for equity holdings in defensive stocks.

However, the investor will need to pay close attention to the nature of the event that caused the latest volatility and which particular sectors are likely to prove ‘defensive’ during the latest market crisis. Sectors that are traditionally seen as defensive during market downturns – such as commercial and professional services, real estate, and consumer services – turned south when the coronavirus first rattled markets in March 2020, particularly consumer services, while sectors not normally seen as defensive including technology hardware and software, semiconductors and semiconductor equipment, and media and entertainment, put in positive performances. ii

Search out oversold assets

During the initial stages of a market crisis such as that unleashed by the COVID-19 pandemic in March, it might be impossible to properly diversify or reweight a portfolio as all sectors – including what in any other time would be considered safe havens such as gold, bonds or the dollar – were routed. Unless an investor managed to sell at the precise height of the market before the slide began, a safer approach might have been to wait for markets to come off their bottoms before reassessing acceptable risk levels within a portfolio and diversifying or reweighting accordingly.

This might also be the time to search out investments that the market appears to have oversold. This would, of course, form part of the high-risk portion of an investor’s reweighted portfolio, as by its nature this would mean going against the market consensus. But if an investor can judge this right and the timing is good then returns can be high. It might not normally be wise to speculate in this way, but fear also shouldn’t cloud judgement. After all, the market consensus is by no means always right. And if the market has taken a clearly short-term view of a particular stock or asset, reacting to headline news rather than holding on to an asset with strong fundamentals, then buying when the price is low would fit with a long-term, rather than speculative, investment strategy.

As markets start their recovery, investors may begin to move out of potentially overbought safe havens and scour the markets for buying opportunities, particularly of stocks that were sold off during the first flush of the crisis, but where the impact on the underlying business may not be permanent. So long as they can survive, there could be an upswing in fortunes for companies that were heavily sold off once the pandemic finally recedes.

Another means of hedging against short-term corrections in stock markets is to buy put options on broad-based indexes that closely match an investor’s portfolio. This is an advanced strategy, however, and the costs of hedging in a volatile market may outweigh the potential benefit, so it may pay to spread some of the cost of buying a put option by selling another high-cost option. Another strategy to hedge against losses could be using stop losses or buying assets with a negative correlation to the asset an investor is trying to hedge.

Learn from mistakes

Other things investors will need to watch for include execution delays during high volumes of trading (with executions happening at different prices from those quoted at the time an order was placed), or difficulties executing trades when a system’s capacity has been reached or, if trading online, when web traffic is abnormally high.

Market conditions can affect trade, so in fast-moving markets the price you get might be very different to the one that was quoted. In such conditions, a limit order – placed with a brokerage to buy or sell a predetermined amount of shares at or better than a specified price – can be useful, even if it might cost a little more. A limit order does not always guarantee an execution, however.

Finally, it’s useful to remember that we are all human and prone to mistakes. Common errors include over-reacting to attention-grabbing news releases, holding on too long to winning stocks as though the gains will continue forever, or clinging on to losing stocks in the forlorn hope that prices will turn around. It therefore pays for an investor to be extra self-aware while markets are in turmoil and to constantly question their own assumptions so as to ensure that emotions and prejudices don’t cloud their judgement.

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