The Globe and Mail, Report on Business
Published October 15, 2010
When investors open their quarterly statements this month, they’ll be pleasantly surprised. Despite all the doom and gloom, the last three months have brought a year’s worth of returns.
But despite the fact that the most recent quarter will bring the fifth good news statement out of the last six, it won’t change the fact that investors are worn out and discouraged.
I’m generalizing grossly of course, but there are strong indications that many people are losing faith in stocks and investing in general. Balanced portfolios have earned 3 to 4 per cent annually over the last 10 years, which feels like nothing compared with the previous 10 (and may literally be nothing if a few mistakes were made along the way). In hindsight, a similar return could have been achieved by rolling five-year GICs.
Disappointing returns are at the core of investor disillusionment, but I think an equally important factor is the volatility that has gone along with it. In 10 years, investors have had two hair-raising bear markets and two equally impressive recoveries. The swings between quarterly statements have been nothing short of remarkable and have spooked investors. Now they’re saying, “I want some growth, but I can’t take any more losses.”
For those who are drawing on their portfolio for income and have a shorter time horizon, volatility is certainly something to beware. These investors can’t afford to have markets dip just when they need money.
But for investors who have the luxury of time, volatility doesn’t equal risk, not in theory anyway. These investors can hold assets with a higher potential return knowing that short-term price swings are inconsequential. Long-term returns are what matter. Risk is holding overpriced assets, being too concentrated on one type of investment, and having no protection against inflation. Risk is having a portfolio that doesn’t fit with their objectives.
John Thiessen, manager of the Vertex Fund, captured this issue well in a recent note to unitholders. “Every day we start our day trying to reduce risk in our portfolio but not necessarily volatility. Volatility in the short term is hard on stomachs and nerves but in the long term will deliver better investment returns. Investment policies suffer from a tendency to equate volatility with risk and an indifference to whether assets are cheap or expensive.”
While John is able to put theory into practice, the same can’t be said for most amateur investors, and more professionals than I’d like to admit. The reality is, volatility brings with it so-called execution risk – the risk that investors won’t be able to hold on when prices are down and sentiment is negative (or control their enthusiasm when times are good). It’s great to say you’ll buy when stocks are at their lows, but it’s quite another to consistently do it. Indeed, in the face of peer pressure and marketing hype, it’s easier to do the wrong thing. Even a simple strategy of regular contributions and re-balancing can get off track in highly volatile markets.
A high-potential, high-volatility portfolio should generate better returns over time, but it has to match up with the investor’s psychology. As investment professionals, we run the risk of doing what trainers at the gym do. Too often they develop textbook programs with all the required exercises, but fail to take into account their clients’ time, willpower and exercise history. Routines that are shorter, less perfect and more fun would have more staying power and get better results.
In the investment context, Dan Hallett of Highview Financial Group has done research that suggests investors in less volatile balanced funds have a longer holding period and achieve better returns than those in all-equity portfolios.
For long-term investors, volatility shouldn’t be a risk factor, but it clearly is. Today it’s showing itself in client portfolios that have strayed far from their long-term asset mix. Investors are holding too much cash and are slow to invest new money. They are likely to delay doing any re-balancing. In general, they’re frozen.
Investment professionals must make sure that our recommendations are realistic for our clients, but we’ve also got to help them absorb more volatility. I don’t know what the markets are going to do over the next year, but I do know that portfolios that are trying to avoid downside volatility will not meet their goals in the long term.