Coping with market ups and downs

• We expect the prices of stocks and bonds to continue moving up and down over the coming months as governments and central banks try to support the global economy.

• Inexperienced investors can become nervous and make some rash decisions.

• We believe the old adage of "buy and hold" could serve investors well over the longer term.

After years of synchronized rises, the prices of stocks and bonds are facing a less certain future. Just as a preliminary US-China trade deal was being signed, and as the UK and the European Union started to discuss their future relationship, the Covid19 pandemic has undermined the potential for further gains in the near term.

This begs the question of how investors should prepare for, or react to, the coming ups and downs in asset prices. We believe that the most appropriate answer is surprisingly simple. Ups and downs

The rapid movement of prices in assets such as stocks and bonds is referred to in financial circles as volatility, and volatility tends to be most prevalent when investors have doubts over the near future. This co-ordination between worry and price volatility is shown in Chart 1.

Volatility on the horizon

Since 2003, the VIX has mostly moved between 12 (which is regarded as low) and 30 (which is moderately high). There have been some sharp spikes as investors digested developments such as the Greek financial crisis, the Chinese currency devaluation and global growth concerns. These spikes became more frequent in 2018 and 2019 as US trade sanctions and global geopolitical uncertainty preyed on investors’ minds.

The point to note is: every time a major concern has come to the fore, the VIX has risen and stock prices have dipped.

While the prices of stocks and bonds have been rising for a number of years, this appears unlikely to continue in the near term as the Covid19 pandemic forces countries and companies to close. This has triggered a collapse in global economic growth. It is also leading to a rise in borrowing as governments issue bonds to fund the support they’re providing to citizens and businesses.

Central banks (such as the Bank of England) are also doing what they can to maintain economic growth by lowering interest rates.

Common mistakes investors make

The coming months could be challenging for investors and present some common but nasty traps for the unprepared.

A study by the University of California [1] identified a number of common mistakes that individual investors make. These include following the herd when buying or selling, trading too often, and not having a sufficiently diversified portfolio.

The academic paper found that investors would follow the herd and buy when everyone else was buying (often when prices were about to fall), while selling when everyone else was selling (and prices were about to rise) [1]. One simple solution could be to trade less because, as the research determined, “investors who trade the most perform the worst” [1]. In other words, doing nothing can be the most effective policy.

However, that inaction is dependent upon holding a diversified portfolio. Returning to the research again, “a fair bit of evidence suggests that many investors fail to effectively diversify”. In other words, investors should spread their investments across a range of assets designed to mitigate the effects of political and economic challenges.

How should investors react?

We agree with all of these observations.

We believe that staying invested in a diversified portfolio and not worrying too much about what’s going on in the short-term is one of the best policies, if not the best policy. In other words, “buy and hold”. It’s a boring message and one that we repeat, but we do so for good reason.

As an example of this, on 31 October 2007 the S&P 500 was at its then record-high price of 1549. An investor buying a basket of shares that copied the S&P 500’s performance would have seen their investment drop by more than half over the subsequent 18 months as the S&P 500 fell to 735 on 27 February 2009. If they had sold at that point (as so many did), they would have locked-in those losses.

However, if that same investor had maintained a 10-year horizon, as we do, they would have seen the S&P 500 rise to 2575 on 31 October 2017. That’s an overall gain across the 10 years of around 66%. As always, it should be noted that gains are not guaranteed, and past performance is not an indication of future performance be it good or bad.

In short, our preferred strategy is to focus on the long term, diversify and avoid being distracted by the noise.

Sources:

[1] “The behavior of individual investors”, Barber and Odean, University of California, 27 June 2011.