Volatility is not the Villain

Volatility is not the Villain
 
Investors should not be spooked to read that economists and investment strategists believe that “market volatility is expected to increase”.  

In finance, volatility is typically akin to standard deviation and is simply a measure of change (both upside and downside change) relative to an average.  So increased volatility of equity markets should be interpreted to mean that, in the short-term, share prices are expected to fluctuate more.  Shares fluctuate – this is not news – and people who invest in equities should be psychologically prepared for stocks to fluctuate!
 
However, in what appears like a case of Chinese Whispers on the statistical measure of risk (that is standard deviation) and the Oxford dictionary’s definition of risk (“A situation involving exposure to danger”), many unversed investors mistakenly interpret volatility to mean permanent share losses. 

The Little Book of Market Myths (published in 2013) includes some interesting data on stock market volatility highlighting that high volatility does not imply stock loses (and visa versa); 1933 was the second most volatile year ever for US equity markets with standard deviation of 52.9%, but stocks rose a massive 53.9%. Whereas in 1977 standard deviation was only 9.0% (roughly half the long-term average) yet stocks fell 7.4%.
 
Increased volatility in share prices may be due to a raft of factors, including uncertain economic conditions or even increasing algorithmic trading, but generally reflects diverging market sentiment such that share prices have or will deviate from reasonable valuations - i.e. in the short-term the market is becomingly increasingly fearful, in which case share prices decrease, or increasingly greedy, in which case share prices rise. 
 
While investors shouldn’t expect to predict when short-term market fluctuations may occur, volatility may present pricing opportunities to acquire quality companies at prices below their intrinsic value thus providing increased investment returns over the longer-term. For instance, just recently we have witnessed a global selloff of technology stocks which has seen share prices of some stocks reduce by as much as 30% in 3 days trading.  Subsequently some institutional investors, such as Mark Mobius at Templeton Emerging Markets who oversees US$50b funds under management, reportedly used this as an opportunity to buy certain technology stocks because they were then trading at “reasonable” valuations.

It’s important investors don’t get caught up by “momentum investing”, that is buying a stock because it’s gone up or selling a stock because it has gone down.  It’s this sort of behaviour which is in fact risky (this time using the Oxford dictionary definition!) as investors are more likely to buy shares above fair value or sell shares below fair value. 

So next time you read a statement that “market volatility is expected to increase”, fear not, short-term fluctuations (if managed correctly) should not impair investors long-term goals and may even provide opportunities to invest in companies that may have previously been too expensive.

Zoie Regan, Senior Investment Analyst at Fisher Funds
www.fisherfunds.co.nz