Periods of high volatility can be unnerving. We’re told that long-term returns are the only thing that matters, but it’s difficult to remain calm when our investments’ short-term performance looks bad.
Stock markets worldwide have been more volatile this year, but investors have suffered from particularly painful falls in share prices in recent weeks.
The recent turmoil in global financial markets was triggered by data suggesting weaker economic growth in China, the world’s second largest economy, following a surprise devaluation of its currency earlier this month.
Chinese stock markets suffered some of the biggest declines in share prices, adding to the significant sell-off that began in June. However, fears about the wider implications for the global economy, including companies that sell goods and services in China, led share prices to tumble around the world.
As a result, the FTSE 100 index of British shares dropped to below 6,000 at one point, having surpassed 7,000 earlier in the year, while commodities markets, which are heavily dependent on demand from China, also fell heavily.
Some investors fear a weaker Chinese Yuan could lead to the spread of deflation, or falling prices, across the developed world. Falling asset prices are worrying because it can depress consumer spending and proves painful for debtors. They see the cost of their borrowing rise in real terms.
Following weeks of volatility, the Chinese authorities stepped up support for share prices with a series of measures, including cutting its benchmark one-year lending rate by 25 basis points to 4.6% and the one-year deposit rate by 25 basis points to 1.75%. The moves have led stock markets around the world to rally, recovering some of their losses.
But a broader reason for the turmoil could be worries about an impending increase in interest rates by the US Federal Reserve. Central banks in both the US and the UK are moving to normalise monetary policy, ending a period of record-low interest rates and quantitative easing (QE) that has resulted in unusually calm bond markets and rising share prices. This has pushed up the cost of equities around the world.
Janet Yellen, chair of the Fed, has hinted that US interest rates could rise next month, although this isn’t likely to happen until March next year now following the setbacks on stock markets.
Even so, volatility is likely to continue. So how should investors respond?
Whenever the prospect of a sell-off seems to be particularly severe, there is a temptation to reduce exposure to the market. Once the threat has diminished, we can buy back in, hopefully at lower valuations.
However, it is almost impossible to distinguish between a genuine, imminent crisis and a mere market wobble over an event that proves far less serious than anticipated. As a result, investors who spend too much time waiting for the right moment to invest may miss out on many of the gains.
For example, over the last five years, some investors have kept part or all of their cash on the sidelines. In waiting for the global economy to become a safer place, they have missed out on very significant gains in most asset classes.
The implication is that unless markets are clearly extremely overvalued, your best approach may be to stay invested and try to manage the psychological effects of high volatility. That’s assuming, of course, you are investing for the long term.
If your goal is to retire comfortably in several decades then you have more time in which to regain any losses resulting from short-term volatility. But if you need to access your money sooner, you may wish to rebalance your portfolio. For example, you could move towards asset classes that have historically been less volatile or move into cash.
Focusing on the long term is more easily said than done, but adopting a sensible strategy of diversification should temper the volatility of your portfolio. This means both diversifying within asset classes and among asset classes.
For example, a fully diversified portfolio of stocks will be less volatile than holding just a handful of stocks. No matter how effectively you diversify though, your investments can still fall in value so you may get back less than you invest.
Investors should also consider whether they want to diversify their stock holdings globally, rather than confining themselves to the UK market. In doing so they could benefit from the different performance of international markets.
Note, however, that international diversification can expose investors to another form of volatility: foreign currency risk. This is where the value of investments can fall owing to a decline in the sterling value of foreign currencies.
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