By Dr Shane Oliver
Chief Economist and Head of the Investment Strategy team
After a period of relative calm over 2012-2014 share market volatility has spiked over the last year as various worries about the global growth outlook intensified. With this renewed volatility a focus on risk in investing and a desire for safety has naturally come. In the video below, we consider the role of cycles, compound interest and noise when comes to managing market volatility.
There is always a cycle
Periods of volatility come and go. In a cyclical context, volatility tends to:
- Be quite low during the mid-cycle phase of the business cycle – that is, when growth has picked up after a downturn but before the economy is too strong. This is when the economy is most stable and arguably predictable, corporate debt is low, interest rates are moderate and shares are not at extreme valuations.
- Rise during the boom, bust and then initial recovery phases in the business cycle. This tends to be when economic surprises – both good and bad – are at their greatest. It is also when sharemarkets tend to become most misvalued and when investors take extreme positions.
It’s hard to put the recent volatility down to a move into the boom/bust phase of the cycle because there is little evidence to support it: global growth is far from booming, inflation is low, debt growth is low, shares are not overvalued, investors are not complacent and monetary policy is far from tight. These considerations suggest that we are not on our way to a re-run of the sort of volatility seen around the global financial crisis.
Recognise the power of compound interest
Time is on your side when it comes to investing – as it smooths out short term volatility. For example, while share market returns can be highly volatile over short term periods they tend to be quite smooth over long periods. Since 1900 for shares roughly two years out of ten have had negative returns but there are no negative returns over rolling 20-year periods.
Turn down the noise and focus on the long-term
During volatile times in markets the negative news flow via traditional and social media can reach fever pitch and this is when we are most prone to making emotional decisions regarding our investments and joining the crowd. The trick is to turn down the noise around investing.
What does this mean for investors?
We may have to get used to high levels of volatility for a while yet. There are some reasons to expect volatility to remain higher than seen over the 2012-14 period: on some measures US shares are overvalued; corporate debt in the US has gone up; the US Federal Reserve (Fed) is still heading down a path of gradual rate hikes; the divergence between a tightening Fed and still easing other central banks is likely to create tensions in terms of currency shifts; the bust in commodity prices is likely to continue to have an impact; and finally swings in investor sentiment will continue to play an outsized role.
High levels of investment market volatility often indicate opportunities for investors as this is often when shares are cheap. In fact, periods of low volatility when markets are smooth and investors relaxed can be periods of maximum risk. As such, don’t get thrown off the cycle into a strategy which is overly conservative.
During volatile times the key is to avoid the emotional investing driving the crowd, look for the opportunities that volatility provides and stick to a long term investment strategy.