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The Markets Are Less Volatile Than You Think

Many Canadians have been led to believe market volatility has increased, and they’ve made investment decisions based on that premise. The reality? Volatility hasn’t been this low in more than 20 years.

 

Date: October 6, 2017

If you listen to most investment experts and financial pundits, you’ll hear a lot about how markets, which have been on a bull run since 2009, are in for a rough ride. With every market move dissected to the nth degree and a general feeling of nervousness that years of equity gains will soon reverse, it’s no wonder many investors think market volatility is at an all-time high.

However, the reality is far different. While all markets have their ups and downs, volatility is at the lowest it’s been in decades. The CBOE Volatility Index, a popular measure of investor fear – it uses options data to indicate what the S&P 500 might do over the next 30 days – hasn’t been this low since December 1993.

Yet many investors are gripped by a fear of volatility and are making investment decisions based on a perception that the market is moving more than usual. This thinking could be putting their long-term investment objectives at risk, says Tony Elavia, Executive Vice-President and Chief Investment Officer at Mackenzie Investments.

AN INCREASE IN INVESTOR FEAR

There are several reasons investors think the markets are more volatile than they are, including the financial press’s fascination with market movements and its overreaction to down days. “People keep harking back to the financial crisis, even though it’s been 10 years,” says Elavia. “The media keeps that spectre alive by comparing everything that happens today with 2008.”

The financial services industry could help investors improve their understanding of market risk so they can avoid anxiety about taking on any risk, which might affect their willingness to seize opportunities, he says.

A misplaced fear of impending market turbulence ultimately holds investors back and causes many to stay on the sidelines or invest in products that won’t help them save for the future. “They’re mis-investing and taking much less risk than they’re supposed to, and their returns suffer,” says Elavia.

Over the past few years, investors have embraced low-risk strategies in droves, driven in part by their nervousness that markets will turn. Fortunately for them, these strategies have done well, just as many investments have in this bull market, but this has led some investors to wrongly conclude that low-risk investing always outperforms.

“Just because something has done well in the last few years doesn’t mean it’ll continue to do so,” says Elavia. “To extrapolate from the recent past is a big flaw in how people make decisions. In the past year, we’ve seen a substantial reversal, in which low-volatility strategies have significantly underperformed across geographies.”

Of course, investors can’t be complacent either. They should understand how much volatility they can stomach and how much risk they need to take on to meet their financial goals – and invest accordingly. It’s also a good idea to stop reacting to the news, he says.

CHOOSE THE RIGHT INVESTMENTS?

So what happens when an irrational fear of volatility impacts someone’s investing decisions? The investor either purchases the wrong products or underinvests, says Elavia.

For instance, those who have predictable incomes and can save a significant portion of their paycheques should have a greater allocation to equities, yet they may be more heavily invested in fixed income. That can be a problem, as equities generally outperform bonds over the long term.

Skittish investors also tend to pile into safer equity strategies and avoid international markets. “They lose out on all the benefits of global diversification and emerging-market returns, which are generally expected to be higher than those of the domestic market,” says Elavia.

Investors may also be playing it too safe with their bond allocations. In today’s low-yield environment, most people need some exposure to corporate or high-yield fixed income and fewer assets in government securities. “If you underinvest, you’ll have more government bonds and less corporates, and your returns will suffer,” he says.

WHEN TO WORRY ABOUT UPS AND DOWNS

There’s another problem with being afraid of volatility: You end up forgetting that ups and downs are a natural part of investing. In fact, investors need market movement to be successful. It’s when the market falls that the best opportunities tend to present themselves, says Damon Murchison, Mackenzie’s Senior Vice-President of Retail Sales. “When there’s volatility, it presents an opportunity to invest at cheaper or more reasonable prices,” he says.

Those who fail to remember that markets rise and fall and rise again end up panicking during a downturn. While markets can drop rapidly – a correction of 10 percent tends to spook investors, but even that’s a normal occurrence – they always come back as people start buying on the dip.

At the same time, thinking the markets are always going to climb can be harmful as well. “People make poor decisions during all cycles, but a lack of volatility could mean there’s complacency – and then people do not assess risk properly and things get out of hand,” says Murchison.

In many cases, investors get so excited about the money they’re making in a bull run that they assume it’s going to go on forever. Having a good advisor, one who can manage one’s emotions in both up and down cycles, is critical, he says.

STAY THE COURSE

To be financially successful, investors can’t overthink volatility or base investment decisions on whether the market might fall or rise. “You have no idea when stocks will drop by five percent or seven percent,” says Elavia. “You may wait for a long time. Meanwhile, the market may go up 50 percent.”

For those prone to a high degree of risk aversion, Elavia recommends a strategy that incorporates what he refers to as the “stepping-stone products,” which are halfway between fixed income and balanced funds, with a mix of equities and bonds. “These investment vehicles have the characteristics of balanced funds but will give you the comfort of some downside protection when equity markets go down,” he says.

There is a trade-off between risk and return, though. While these funds provide greater downside protection, they also come with a lower return. “If you just stay invested in these strategies, you’ll make less money over time,” Elavia cautions. “But if you’re so concerned about the future, you should invest in a stepping-stone strategy.”

It’s also beneficial to work with an advisor and to come up with a good plan you can stick to, he says. Find the appropriate mix of mutual funds, ETFs and other securities that are consistent with your investment goals.

Ultimately, the idea is to remain invested in whatever asset classes you choose. “Don’t jump in and out,” says Elavia.

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