Four myths of market volatility
The return of index ups and downs has made investors jittery. It’s a good time to debunk some of the myths surrounding market volatility.
Since the FTSE/JSE All Share Index hit an all-time high on 29 July last year, we’ve witnessed the return of index ups and downs – locally and internationally. Investors are becoming nervous and checking with their advisers whether it’s time to get out of the market.
Let’s look at four of the myths and whether there is any truth in them.
1 High volatility = negative historical returns
Volatility is simply the extent to which an investment’s monthly returns deviate from their average on a month-by-month basis. High volatility does not necessarily mean an index or a fund’s returns have been negative often. It means the returns fluctuate in a wider range than is the case for an investment with a lower volatility.
For example, a typical Fund may have quite dramatic swings between stellar and pedestrian monthly returns, but no negative months. It therefore has a higher volatility or standard deviation, say 1.8, than another Fund with a deviation of 0.8 which has poor but consistent monthly returns.
2 High volatility = an approaching bear market
We did some research and found no conclusive evidence that increased volatility is a precursor to a bear market. Over the past 15 years, there were three periods during which the volatility index (VIX) exceeded 35 (around 20 is the average).
Those periods were August 1998, September 2002 and March 2009. To investigate whether higher volatility introduces a bear market, we’ve plotted the VIX index against the monthly and quarterly returns of the FTSE/JSE All Share Index and the MSCI World Index for the three periods following the VIX peaks..
We found there were some negative monthly returns after each volatility spike, but one or two months hardly count as a bear market. If you look at the quarterly returns after each spike in the VIX index, there were in fact no negative quarters.
Therefore, although we refer to the VIX as the ‘fear index’, there is no evidence that a rise in the VIX necessarily introduces a bear market.
3 Volatility is a good reason to stay out of the market
A common mistake that investors make is to take their money out of the equity market soon after experiencing one or two sharp negative months. By sitting on the side, they run the risk of missing out on some of the best returns of the decade.
The bar chart below shows the impact in case you missed the best 10, 20 and 30 days of the last 10 years. And the longer you stay out of the market, the greater the risk you run of sacrificing returns because of your fear of a bear market (which may never materialise).
4 Volatility doesn’t matter
Long-term investors invest in riskier, more volatile assets to beat inflation over time. Volatility is therefore one of the tools used to outperform the conservative portfolios aimed at short-term investors. Volatility is the friend of the long-term investor. It matters.
Unlike short-term investors, longer-term investors have time on their side to sit out the ups and downs of the equity market. The graph below shows that, provided investors are willing to remain invested in the All Share Index for at least five years, there is little likelihood of capital loss over the full investment term.
Stay the course
By staying the course and ignoring the ‘noise’ of short-term market fluctuations, and remaining invested through all market cycles, long-term investors will reap the rewards of patience and persistence.