Becalmed in a teacup

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    Written by Greg B Davies 22 June 2014

Nothing in life is as important as you think it is, while you are thinking about it” – Daniel Kahneman, Thinking, Fast and Slow

The calm before the storm? 3 of 5 Planting a flag 1 of 5

Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

Investing is an emotionally uncomfortable activity regardless of market conditions – and being in the market right now may feel a little more awkward than it has for a while. For the first time since 2006, we’ve had a relatively prolonged period of market calm and consistent returns. But rather than enjoying the absence of the daily swings between ‘risk-on’ and ‘risk-off’, many commentators seem to be getting increasingly nervous about the calm itself.

‘Will volatility increase again?’ This seems to be the question of the moment, but luckily we can answer it fairly easily: ‘Yes, it will.’ Unfortunately, we don’t know why, and we don’t know when. However, if this is the question keeping you awake at night, it might be worth asking a different one: ‘Is volatility what I should spend my time worrying about?’ The answer here is a clear ‘no’.

For a long-term investor (and there really shouldn’t be any other sort), volatility – be it high or low – is considerably less important than we think it is. Low volatility may well be a sign that the markets are complacent about short-term prospects, but volatility tells you almost nothing about the long-term value of being invested. In short, people are getting themselves worked up about good news from a measure that doesn’t matter very much. Volatility has a great deal of short-term emotional resonance, but is largely disconnected from your long-term performance. I use the word ‘largely’ because, while volatility will have little effect by itself, its influence on your investing behaviour can have huge long-term consequences.

Many investors are waiting for the ‘magical’ right moment to invest

How, then, should we respond to the recent outbreak of calm? Is it better interpreted as confidence or complacency? Let’s examine the consequences either way. If volatility remains low for some time before increasing, it could encourage more investors to get into the market. They would be doing the right thing – although for the wrong reason. For the last five years, the vast majority of investors have been, to a greater or lesser degree, sitting on the sidelines, burnt by the financial crisis, and waiting for that magical ‘right’ moment to invest; this has cost them huge amounts in foregone returns. These investors may now, at last, be comfortable enough to put more of their wealth to work.

Of course, it would have been better if they had come to this conclusion earlier – their long-term returns would have been higher due to buying lower and investing longer. But nothing can be done about lost opportunities, and regret is never a good basis for an investment decision. Over the long term, investors get rewarded for providing capital for others to put to productive use in the economy. Over long periods of time, equities earn, on average, a substantial premium over cash, and it is only when equity markets are extremely over-valued that long-term investors should avoid them. Even when they are above fair value, equities outperform cash over long periods. So, you may have missed out on the very best entry points by only investing now, but as discussed in the subsequent essay, ‘The calm before the storm?’, the equity markets still look much better than sitting in cash for the long term, on a forward-looking basis.

The bigger danger is that you believe the press, and start to see the low volatility as a harbinger of catastrophe, leading you to either stay uninvested, or sell existing investments to protect your portfolio. Having run out of excuses not to invest from high volatility and recent bad times, you may now find excuses from low volatility and good times. The crucial thing to realise is that volatility is about short-term turbulence – and therefore discomfort in the markets – but, as a long-term investor, it makes little difference to where you end up. If you act to protect yourself against volatility, you’ll be giving up long-term upside to purchase short-term protection that you don’t need.

But, since we expect volatility to increase, aren’t we better off waiting for a more attractive entry point? Perhaps – but such a strategy only works under two big assumptions. First, that when the volatility spike comes, it will cause markets to fall to a lower entry point than their current valuation. This may not be the case. We can be pretty confident that, at some point, markets will get choppy again, but they could quite easily keep rising calmly for some time before this happens. When the volatility comes, the dips could still bottom-out well above where we are now – in short, there may not be a better entry point ahead.

Second, even when the market does drop – whether to a point above or below today’s level – the ‘wait-for-the-dips’ strategy assumes that we will swiftly recognise that the market has hit the bottom, and then be able to act on it. ‘Wait and see’ is a comforting excuse to spin for ourselves, but we may be waiting for something that never happens and, even if it does, we may find ourselves too paralysed to make use of it. On average, over medium to long periods, investing pays better than not investing. If you’re not in the markets (in a diversified portfolio) the odds are not in your favour, and the best times to get in are invariably when it is most nerve-racking to do so. Ultimately, it is better to get in as soon as you can and stay in than to gamble on your ability to do the optimal thing in moments of future stress.

Thus, if low volatility causes you to protect your portfolio against things you don’t need to be protected against, it can be very costly. There is, however, one good thing to be said about worrying about the calm in a teacup: if (rather, when) short-term volatility does spike, you are going to need to be prepared, not financially, but emotionally. When turbulence re-enters the financial markets, we’re all going to be tempted to run for the exits. The best response is to do nothing and sit tight, but there is every danger that those who are currently complacent will find themselves emotionally unprepared when the world once again reminds them it is not a perennially pacific place.

We should recognise that markets will once again be rough seas to sail on, but rather than act on misplaced concerns about the effects of volatility on your long-term financial state, we should use it to prepare for the very real effects of high volatility on our short-term emotional state. We all need a reservoir of emotional liquidity to see us through turbulent times – better to build up that liquidity, now, in times of calm. Ultimately, good investing is about learning to worry about the right thing – it’s not volatility but the fear of volatility that threatens long-term returns the most.