To state the painfully obvious, the coronavirus outbreak has led to a huge increase in market volatility over the past few weeks. In this blog, I look at the situation from different angle: instead of focusing on the immediate virus effects and policy responses, I dig deeper to explore some of the risks and opportunities that arise in volatile markets, and underline how important it is for investors to remain calm and stick to their principles.
Pound cost averaging
I often hear that volatility can be an investor’s friend, thanks to the benefits of pound (or dollar) cost averaging. The idea is that if markets are fluctuating around fair value, you will naturally buy more shares when they are cheap than when they are expensive. As an illustration, suppose you have £100 to invest and you spread your investment purchases out:
- You spend half your money when the shares are 30% undervalued. Let’s say shares are 70p when their fair value is £1. This will bag you £50/£0.70 = 71.4 shares
- You spend the other half when the shares are 30% overvalued. This will get you £50/£1.30 = 38.5 shares
- So you have 71.4 + 38.5 = 109.9 shares in total
- You eventually sell these at fair value (once the market has calmed down) for £1 per share.
- You make a c.10% return exploiting volatility around fair pricing, because you spent £100 but got back almost £110.
However if markets are efficient, following a random walk, this benefit does not exist because the market is never ’overvalued’ or ‘undervalued’ and prices do not revert towards an average. Averaging-in is then only a behavioural strategy – effectively a mechanism for avoiding regret - as various commentators, including Cliff Asness, have explained.
Fundamentals versus sentiment
In practice, markets are complicated and returns are driven by a combination of:
- Changes in fundamentals, which can be thought of as the projected dividends or other cashflows ultimately paid to investors; and
- Changes in sentiment, or appetite for risk. This can be thought of as changes in the required rate of return. The ultimate dividends may not have changed, but investors may require a higher or lower risk premium to persuade them to invest or stay invested. As the risk premium goes up, prices go down because the cashflows are discounted at a higher rate.
In a crisis, prices fall and the fall is typically driven by a combination of both (a) and (b). Determining how much is (a) and how much is (b) – and how this mix depends on conditions - is very tricky and academics often debate this as it is closely linked to market efficiency.
An aim as an investor is to exploit (b), or at least not fall victim to selling low, and you can pick your favourite Buffett or Graham quote here. Classics include “we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful” and, “in the short run, the market is a voting machine but in the long run, it is a weighing machine.”
However, even then life is not that simple. Although the risk premium may have gone up in a crisis, the volatility has also gone up, so on a risk-adjusted basis (think Sharpe ratio) ’cheap’ assets may not be quite the bargain they first appear*. There can also be momentum in the markets, at least in the short term. Investors sometimes speak of trying to catch a falling knife.
Short-term losses are naturally painful, but they are also a virtually inescapable feature of investing in return-seeking assets. It is important to put the losses in context and not fall prey to the influence of loss aversion. It is also important to remain humble and diversified (however tempting it is to think we’re all now virology experts) and so not making any rash decisions when it comes to changes in asset allocation.
Investors can’t do anything about any losses they may have already sustained. But what they can do is revisit their portfolios on a forward-looking basis (adjusting assumptions where appropriate), remind themselves why they have invested the way they have, and focus on principles of portfolio construction to help guide their future decision making. Keeping calm and rational is much easier said than done. At times like this it is particularly difficult, but more important than ever as investors.
* Mind you Buffett would also warn against the likes of me – “beware of geeks bearing formulas”!