How portfolio construction can beat volatility

How portfolio construction can beat volatility?

Author: Steven Crouse

Volatility is simply defined as a pattern when the performance and direction of an asset’s price is liable to rapidly and unpredictably change, especially for the worse. Considering the emotional attachment people inherently have for their hard-earned capital, volatile asset prices isn’t a pleasant thought!

Over the past few years, global asset markets have displayed levels of volatility not seen for some decades. In the past two years alone, equity markets have corrected by more than 10% on no less than four occasions: September and October 2014; the period from 24 April 2015 to late June 2015; from early November 2015 through to January 2016; and lastly, post-Brexit at the end of June 2016.

Imagine the turmoil; the emotional roller-coaster and ensuing decision making? Do I sell out and switch to cash to avoid any further losses, and if I do, at what point do I switch my capital back into the market? If I sit on my cash, blissfully avoiding any volatility, what damage am I doing to my long-term goals by not achieving above-inflation returns?

These and other pressing questions abound in the minds of investors across the globe. So if you have recently asked yourself similar questions, you can take solace in the fact that you are not alone. But unfortunately, solace and comfort doth not long-term real returns make! So where does the utopian middle ground lie?

The last decade has seen the rise of a multitude of products and strategies promising to provide greater certainty, lower risk and a smoother ride – passive index funds, ETFs, robo-advice, complex strategies with guaranteed returns etc. But do they really do what it says on the packaging?

As I have previously written in other articles on this blog, in the majority of instances, such promises are nothing more than snake oil and elaborate (and costly!) solutions to problems that can be solved far more simply. During my post-graduate studies, I had a lecturer who imparted on me the wisdom of TANSTAAFL – ‘There ain’t no such thing as a free lunch’. But I beg to differ, as investors the world over are essentially offered a free lunch every day with these simple strategies:

1. Diversify, diversify, diversify!

The age-old adage of not putting all your eggs into one basket sounds so easy, and in many respects it is. The secret is to do it properly i.e. ensure your different assets are truly different and will perform differently across different cycles (a concept called de-correlated).

2. Don’t expect quick returns

Fear and greed are far stronger than long-term resolve, and in a world of instant gratification, investors often make foolish mistakes by expecting boom-like returns from all their investments. Granted, the thrill of quickly growing your capital is exciting, but markets are too efficient for every single investment call you make to be a magical winner (and be suspicious of the manager whose track record is such). The only place you can quickly double your money is the casino… but then you can lose it just as quickly!

3. Stay the course

Time in the markets produces far greater returns than timing the markets. Remember the Rule of 72 that calculates the impact of compound interest? It says 72 divided by your annual rate of return will give you the number of years it will take for your investment to double. Now take your answer to this calculation and double it; that is the number of years it will take for your investment to QUADRUPLE! Volatile markets are not pleasant; they are characterised by the uncertainty of returns; the perception that losses are going to continue forever; and a sometimes significant difference between positive and negative returns, day after day. Yet it is during periods of volatility that the foundation for one’s long-term returns are laid.

Asset prices will recover and markets will turn positive. It may take time and it may result in a further negative returns, but if your portfolio is robust, structured to tolerate some ‘wiggle room’ without you needing to sell out, and has sound underlying investment decisions, it is far more likely to cushion you from extreme movements and keep your strategy on track.