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Volatility in the stock markets – what causes it and why now?

Why has volatility returned? Is it a bad thing? And what should be our response as sensible investors?

Topic: Investing
Alex Neilson Invetsment manager Click & Invest

Click & Invest investment manager Alex Neilson answers these key questions

The investment landscape can often be synonymous with nautical references – facing headwinds, tailwinds and turbulence.

The metaphors got a bit of a rest during the unnaturally calm conditions of 2017. But, volatility returned with a vengeance in 2018 and commentators immediately got back to talking about weathering storms (often ‘perfect’ ones) and battening down the hatches.

All of this can be quite perplexing for investors and begs a number of very sensible questions: Why has volatility returned? Is it a bad thing? And what should be our response as sensible investors?

Perhaps the best starting point is to get our heads around the concept of volatility. Just before Christmas, Jamie Dimon, the chief executive of JPMorgan Chase, one of America’s largest investment banks, said: “Sometimes volatility is good; sometimes volatility is bad.”

That may not sound particularly helpful, but it was a very good point. Volatility matters to a greater or lesser extent depending on your investment strategy. In a sense, to return to our shipping analogy, volatility is like the waves on the surface of the ocean. It can come in the form of a gentle swell or huge breakers. But, what ultimately matters for navigators is the underlying direction of the deep ocean current.

A recent history of volatility

In 2015, markets were extremely volatile – the fluctuations in the main stock indices, such as the S&P 500 or the FTSE 100, were massive. During one day in August of that year, the Dow Jones dropped by nearly 1100 points shortly after the opening bell [1]. Much of this was down to fears about the bursting of the Chinese economic bubble.

But volatility was low over the next couple of years despite such major events as the UK’s referendum vote to leave the EU and the election of Donald Trump as US president. On average, the S&P 500 has over 60 days each year in which it rises or declines over 1%. In 2017, it had exactly eight.

However, it would be wrong to suggest that low volatility means investors are being complacent. Economists argue that it actually indicates a healthy difference of opinion in the market with a balanced mix of bears and bulls (pessimists and optimists).

Beware the stampeding herd

As the old stock market adage puts it: “it takes two views to make a market”. Buyers could find sellers and sellers could find buyers, leading to reasonable stability in stock pricing. The argument goes that it is herd mentality that results in high volatility with most investors looking to buy or sell at the same time – a stock market manifestation of that notorious social media phenomenon, fear of missing out.

Many reasons have been given for the return of volatility last year, which culminated in record-breaking swings at the end of December. America's main stock market index - the Dow Jones Industrial Average – surged by over 1000 points on Boxing Day after tumbling on Christmas Eve [2]. Then it fell steeply again on 27 December.

The notional reasons were the US government shutdown and uncertainty about trade wars with China. However, the underlying reason – as is the case across all major equity markets – appears to be slowing earning growth globally as the long bull market, the decade-long period of rising stock prices and investor confidence, finally runs out of momentum. This sort of volatility is the norm; it was the eerie calm of 2017 that was the anomaly. It suits traders who look to exploit short-term moves in the market.

But – back to our nautical analogy – paying attention to the waves is to ignore the underlying current. You have to be a skilled surfer to catch a wave, but you need a well-designed vessel to make the long voyage. Beware of paying too much attention to short-term volatility. A diversified long-term portfolio, with both equity and fixed income bond exposure, will stabilise your craft.

Taking the long-term view

The long-term is what we should be focusing on; the good news is that the rolling 20-year average performance has been positive for the last 60 years. Even looking at individual years, going back to the 1920s, stock markets rose in three-quarters of those years and the gains in the high years outweighed the declines in the low years.

Historically, the market has been shown to pull back by around 5% a quarter, 10% once a year and by 20% once in a market cycle (that 20% correction is the definition of a bear market).

The best guidance for investors therefore comes in the immortal words of Corporal Jones from Dad’s Army: “Don’t Panic!”. Overreacting in the face of market upswings and corrections can lead to over-trading and poor timing – selling low and buying high – both of which penalise long-term performance. Beware of recency bias, the psychological effect that makes us pay too much attention to what has just happened while giving insufficient consideration to the long-term trend.

Above all, investors should stay invested. All corrections are followed by recoveries; markets can swing wildly in the short term but the long-term trend is reassuringly predictable – and upwards. As the Shipping Forecast might put it: “Good; rising.”

With investment your capital is at risk. The tax advantages of ISAs may change in the future and also depend on your individual circumstances.

This article is not intended to constitute personal advice and no action should be taken, or not taken, on account of information provided. Opinions given within this article are the speakers’ own personal views. The views and opinions are effective from the date of publication but may be subject to change without notice.



Alex Neilson is an investment manager for Click & Invest, part of the Investec Group
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