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Don't panic

03 December 2014  |  Portfolio

Investing in shares necessarily involves having to deal with volatility. The sad fact isthat most non-professional investors, and many professional investors, sell at the bottom and buy at the top. Logic says that this has to be so, otherwise the markets would not be as irrational as they are.

There are growing predictions that stock markets are about to get volatile and may be in line for a correction. The AFR looks at a bit of history, showing what happens if you panic:

 

"Say you had $10,000 invested in the local sharemarket in October 2007. A year later your capital had almost halved – a devastating drop. But just as the decline was steep, the ensuing climb was just as steep – at least for a period.

In fact, if you had stayed invested and weathered the storm, it would have taken five years for you to make your money back, as the chart from research house Morningstar shows. A long time, sure, but compare that to where you would have been had you cashed in all your chips around the bottom and waited a year to reinvest – you would have missed the sharp recovery and still be almost 30 per cent underwater on your original $10,000, five years after the trough.

And if you had capitulated, crystallised your losses at the bottom and never reinvested? Then, once again on Morningstar calculations, your pile would be a paltry $6400 five years later. Nobody is predicting another GFC in the near future (or at least, very few). But there is no denying something is in the air. And the risk for investors is that they flip from complacency to panic at the first sign of volatility."

 

This is the Morningstar graph, showing the consequences of following the herd.

 

 

 

 

It shows that it pays to wait out the bad times, at least in theory:

 

 

The question DIY super investors have to answer is can they withstand the downturns? Obviously, those not close to retirement can afford to wait. Those in retirement phase or relying on cash flow may have to think harder. One's own investor psychology is critical:

 

If the recent ASX wobbles set your heart racing and prompted an itch to ditch your shares, then it’s time to reconsider whether you are prepared for the way your mix of assets will perform in an era of higher volatility.

“Forget the upside, what is your tolerance to the downside?” says Crystal Wealth executive director Tim Wedd. “This is the story of asset allocation.”

Wedd says investors need to ask themselves what kind of annual loss would cause them to lose sleep. For you, would this be 20 per cent? Or a 10 per cent plunge?“The second aspect is if you are invested in a stock and it falls 5 or 10 per cent, what will you do? Are you going to seek advice? Are you going to panic and sell? Or would you be happy to ride it out?”

A good baseline approach is to “get back to the basics” now, while the seas remain calm, says Morningstar head of fund manager research Julian Robertson. “Make sure this is money that can be invested for the long term and that your risk profile is appropriate for your situation,” he adds.

Regular rebalancing between asset classes can add discipline to your process through the ups and downs of financial markets, as you sell out of winners, lock in profits, and reinvest in the – now cheaper – underperforming assets. So far, individuals have responded to bouts of weakness in the local sharemarket by seeing it as a chance to pick off stocks on their watchlists at a lower price, says Arnie Selvarajah, CEO of online broker Bell Direct.

“On the days where we have big market movements [down] we have seen more buying than selling,” Selvarajah says. “It’s been a similar trend over the past two or three years – during down periods people are jumping in rather than jumping out.”

 

What also has to be remembered here is just how fragile the financial markets remain. The US economy is recovering. The growth in the services side of the economy is very positive. That should counterbalance the negative effects on the global economy of a waning Europe.

But as Max Walsh points out, re-establishing the cost of capital in the developed world -- positive interest rates and the end of quantitative easing -- will be very difficult. The after effects of the GFC still remain, and may do so to the end of this decade. The interconnection of markets that was at the heart of the crisis is now greater, creating many risks. Walsh says the hunt for yield has pushed equities and bonds into dangerous territory:

Bank of England governor Mark Carney points out that it now takes seven times as long for investors to liquidate bond portfolios as it did in 2008. Back then, investment banks and brokers held large inventories of Treasuries and corporate bonds and were actively engaged in making markets – that is, being prepared to take either side of a trade.

Changing regulations along with risk minimisation concerns has seen a contraction in the ranks of market makers. It is estimated that, in London, inventories of active market makers have contracted by 70 per cent. Over the same period, fixed-income assets outstanding have doubled.

As Carney notes, this is an internationally connected market.

“We know that almost half of the $US70 trillion ($82.6 trillion) in managed assets globally is in funds that offer investors redemption at short notice.

“At the same time, funds are investing increasingly in higher yielding, less-liquid assets. There has been a compression of liquidity risk premia that suggests investors are assuming any future withdrawals from funds would be conducted in an environment of continuous market liquidity and that the value of their fund holdings will not fall substantially when they exit. The risks to that assumption are in only one direction.”

Carney says once the process of normalisation of interest rates begins or, perhaps, if market perceptions shift and it is expected to begin, a repricing could be expected. “The orderliness of that transition is an open question,” he says.

So, too, is the prospect of contagion if investors face extended delays to redemptions in falling markets.

The largest financial market is foreign exchange. Turnover of global equity markets is estimated at $US300 billion a day. In the foreign exchange market that number is $US5 trillion.

The current collapse in oil prices has drawn attention to the large exposure that energy-related companies have to the US junk bond market. In 2005 their share of the junk bond market was 5 per cent. Now it is between 15 per cent and 20 per cent.

With both the euro zone and Japan working desperately to avoid deflation, the risks of bumps and contagion from the global forex market cannot be dismissed lightly – especially given there are now some 40 economies with their currency either tied directly to the US dollar or operating a “dirty float”.

 

 



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