summitV I E W
ABOUT Volatility & Investing by Duncan Morton III, Ian Jameson & Matt McNeal
“The inevitable conclusion is that an investor’s asset allocation, expressed in the traditional manner as percentages of total value in each asset class, should change over time to reflect changing market values, even if the investor’s characteristics are unchanged.” - William F. Sharpe
see disclaimer on last page
Does the description above sound familiar? Welcome to the stock market news cycle. Tens of thousands of analysts focus on every bit of information provided by companies, the media and the internet, in turn supplying their own version of the information to hundreds of thousands of investors around the word. However, the buy and sell decisions made by these investors represent less than half of the total trading volume for stocks on any given day. The other half (or vast majority, depending upon whom you ask) of the trading volume is created by computers processing algorithms that execute any combination of trading strategies in milliseconds. These algorithms are designed to react to chart formations, daily trading patterns, a change in the bid/ask spread, and now even read through news and annual reports and make trading decisions based on the language used by the analysts, journalists and CEOs. These machines make millions of trades every day,
STOP ME IF YOU’VE HEARD THIS ONE...
Do you recall the 2008 American presidential election? Volatile times, right? Good thing it only comes around every four years, or we’d be inundated with campaign slogans and posters, solicitous phone calls, emails, and a 24 hour news cycle dedicated to the race. Voters would be forced to make decisions based on simplistically distilled versions of complex issues with very little reaction time. That would be a tough job.
“The loser is the trend-chasing, comfort-seeking investor. The market doesn’t reward comfort. It rewards discomfort.” - Rob Arnott
“In the short run, the market’s a voting machine and sometimes people vote very non-intelligently. In the long run, it’s a weighing machine and the weight of business and how it does is what affects values over time.” - Warren Buffet
getting into and out of positions so quickly the round-trip has to be measured in microseconds. A microsecond is 1 millionth of 1 second. This type of trading can certainly accelerate and exacerbate any move in market prices, sometimes disastrously so (see May 2010 Flash Crash). If it seems like the swings in the market have been more violent and more frequent than in the past, well, have a look at the chart to the right.
As tempting as it is to just blame the machines and joke about contingency plans for the inevitable Matrix or Terminator scenarios, not all of the spikes in volatility are computer generated. The last decade has certainly been a time of heightened uncertainty and disruption across the entire economic spectrum. Since the dot com bubble popped in the year 2000, real economic growth (not just growth propped up by cheap credit and rampant borrowing) has been difficult to find in the Developed World economies. Emerging Markets are a different story, but we can save that for another SummitVIEW. The rise of hedge funds, general nervousness, foreign wars and more unusual theories about long term trading patterns and even astrological cycles have all been identified as possible suspects in the whipsawing of markets.
So, what is an investor to do? Our purpose in highlighting the increased volatility in capital markets is not to scare investors into burying gold in the backyard (though we do know people taking that approach), but rather to acknowledge its existence, and illustrate the opportunities that are created in such an environment. First, to be clear, we are not promoting a day trading strategy designed to ride the ups and downs of the market. With the aforementioned computers playing such a large role in trading, the risk/reward profile of short term trading strategies are a little out of line with that which we are comfortable. We look for long term secular growth stories, and use market volatility to provide favorable entry and exit points
for positions that we like (for reasons other than their short term trading patterns). Though volatility does increase the chance of negative returns, there are tools for managing risk associated with volatility. Allocating assets
based on time horizons of five or more years plays more to an investment managerâ€™s analytical skills and also to the fundamental aspects of a business. Holding cash as an asset allocation strategy also dampens a portfolioâ€™s volatility, and provides the dry powder necessary to invest when volatility brings prices down.
Is volatility risk? Often volatility is confused with risk. SummitVIEW defines risk as the chance of experiencing a permanent loss of capital, not volatility as many traditionally believe. As of October 2010, 50 percent of all trading was handled by computers, either through high frequency trading or program trading. With the increase in computerized trading, volatility has gone up. As mentioned above, computers are programmed to buy and to sell securities based on mathematical formulas. When a stock price
VOLATILITY: The term volatility indicates how much and how quickly the value of an investment, market, or market sector changes. Another form of a permanent loss of capital can occur if an investor’s assets are allocated without recognizing fundamental economic landscapes.
SummitVIEW defines wealth as sustainable purchasing power. Over the years, an investor, at a minimum, should maintain the purchasing power of their assets. In the case of a United States investor, holding U.S. Treasuries exposes one to a loss of capital as the value of the US Dollar declines relative to other currencies that have lower levels of debt and narrower budget deficits. Over time one’s purchasing power declines. The erosion of purchasing power is a permanent loss of capital. Therefore, risk is not volatility but instead is the permanent loss of wealth.
What then is risk management? In “New Frontiers in Benchmarking and Liability-Driven Investing” the EDHECRisk Institute argues that “asset allocation and portfolio construction decisions are intimately related to risk management.”
A permanent loss of capital can occur in a variety of ways. Most telling and obvious is the loss of an investment in the stock of a company. Watching the value of the stock collapse is a very discomforting experience. When a drop in a company stock value occurs as a result of broad market moves (see August 5, August 8 & August 10, 2011), the experience is just as uncomfortable as if the drop were due to a specific company event. However, the two forms of volatility, broad based market moves and a stock collapse due to a company specific event, are different in nature. In the event of broad based market moves, quite often opportunities for investors are unfolding. In the case of a drop in stock value due to a specific company event, often an investor should sell the position as the probability of the stock price rebounding becomes lower. In such specific cases, the investor is faced with an increased likelihood of a permanent loss of capital.
With the aforementioned in mind, how does one measure risk? A common misconception is that risk management is synonymous with risk reduction. Risk management is not only about risk reduction but also about return enhancement through better use of investors’ risk budgets. A risk budget, as defined by the EDHEC-Risk Institute, is the maximum amount of downward price movement an investor is willing to experience, in other words, the percentage an investor is willing to lose. So, if volatility is not an investor’s true risk, then what is? As stated above, SummitVIEW defines risk as the permanent loss of capital.
For example, in the current global economic environment of the developed world the 3 D’s are dominating: Debt, Deficits, and Demographics. Investors who fail to recognize that the combination of high levels of sovereign (i.e. country) debt and high sovereign budget deficits creates volatile global markets expose themselves to a permanent loss of capital. As the populations of the developed world continue to age, aversion to volatility increases, especially for equity investments. In response, many investors flee the volatility of equity markets for the perceived safety of bond markets. In an age of high debt and deficits, removing equity allocations from one’s portfolio is imprudent. Companies have the ability to move resources, including human capital, to where the best market opportunities lie. Unlike a country, a company can move its people and capital to markets where the stockholder will receive the highest rate of return. Believing one can safely protect their wealth by holding the bonds of developed countries, say US Treasury bills, notes, or bonds, requires more faith than we’re willing to grant.
meets certain criteria (daily volume, price level, price/earnings multiple, etc.) the computer submits orders to the exchanges. In the case of a sell-off in the market, selling often begets more selling as the stock price breaks through various levels of price support, e.g. a 50 day moving average. Welcome to the world of connectivity.
Further, the publication states that â€œthe art and science of portfolio management consists of constructing dedicated portfolio solutions, as opposed to one-size-fits-all investment products, so as to reach the return objectives defined by the investor, while respecting the investorâ€™s constraints expressed in terms of...risk budgets.â€? Ultimately, the goal of every investor should be to achieve the most efficient allocation of their capital based on their own particular needs and circumstances while considering the current and future economic environment. That seems like an obvious statement to most investors with more than two neurons to rub together, but it is remarkably difficult to put into practice, especially given decades of Modern Portfolio Theory essentially preaching static allocation approaches. Old assumptions about market behavior directed investors to allocate capital across asset classes in order to achieve the efficient allocation of their capital. An efficient allocation of capital implies one achieves the highest return per the amount of risk one is taking. Often, investors allocate capital in ways that are not in their best interest or fail to achieve the maximum return for the amount of risk captured by the allocation. By focusing more on investment products and security selection as opposed to efficient asset allocation,
Each 1% increase represents $10B in sales. Amazon and eBay must LOVE this one.
investors long term goals quite often are not met. Using buy and hold strategies in capitalization weighted indexes such as the S&P 500 is an example of not efficiently allocating capital. The assumption that one asset allocation fits all economic cycles is out-dated and does not reflect the reality that different periods of time, or economic regimes, require different asset allocations. What worked in the 1990s has not worked in the decade since the dot-com bubble burst. So, risk management is not only about risk reduction but also concerns return enhancement by seeking to achieve the highest rate of return for the amount of risk taken to achieve the return. As well, risk management is about seeking the highest probability of achieving investor long term goals while respecting whatever short term constraint the investor may have. An example of a short term constraint is the risk budget. If an investor cannot stomach their wealth dropping by more than 20%, then that investor should allocate capital such that long term goals and short term constraints are incorporated into the asset allocation. Only by factoring into the asset allocation equation the personal circumstances (short term financial needs/long term objectives) of the
investor with consideration for the current and future economic environment can the most efficient allocation of capital be achieved.
example), these areas serve as focal points for investments in the medium to long term.
The good news is, there are trends that exhibit much less long-term volatility than stock prices, and offer insights into the fundamentals that drive company revenues and market share. See the Efficiency chart on the previous page, which highlights the trend in electronic commerce (e-commerce) as a percentage of total U.S. retail sales. By seeking companies that participate in trends that are global in nature and long in duration, we’re at least working to make sure the volatility in a stock’s price is bouncing Food around an upward trend. We believe that the following long-term economic trends offer compelling risk/reward scenarios: Connectivity, Energy, Food, Healthcare, Mobility and Resources. By viewing these trends through lenses of Aggregate Demand shifts (an ever increasing percentage of consumer spending occuring in developing nations) and the need for greater and greater Efficiency in the use of capital (human, monetary, or resource, for
In making asset allocation decisions for our clients, many different factors are considered. Volatility is but one factor to consider in buy/sell decisions.
Economic regimes last many years, if not decades. The circumstances that led to the economic reality of the 1970s differ from the circumstances investors face today. Today’s economic environment is marked by the characteristics of the 3 D’s: Debt; Deficits; Demographics. With the use of fiat currencies by sovereign entities, one should factor a higher probability of currency debasement into their forecasts for expected asset class returns, especially if your assets are held in currencies where the sovereign entity is running high budget deficits and funding the budget gap with more and more debt.
Investors are better prepared to look through the noise and confusion of the 24 hour news cycles to the underlying, long term opportunities if they can distinguish between short term market gyrations and long term structural trends. Use a longer term time horizon to look past short term volatility, or even better view short term volatility as buying opportunities, much like the oft-referenced blue light special sale of yore. Importantly, by allocating capital efficiently one better serves their long term goals.
Invest efficiently in long term trends.
This Venn Diagram encompasses the themes that we see as important drivers of growth and productivity in the world economy for years to come. It is laid out so that each theme intersects with every other theme, in any combination. While there are compelling “pure play” stories in every theme, it is the intersections between these big ideas that are intriguing. By filtering a company through these themes, a clearer picture is formed of how that company relates to the evolving global marketplace.
Risk & Volatility & Asset Allocation... How’s that?
To start, we have to understand a client’s stomach for risk; do they bury gold in their backyard and keep cash under their mattress, or are they more interested in trading triple-leveraged ETF’s on their smartphones en route to Las Vegas? After getting a sense for the client’s willingness to take risk, we need to analyze their ability to take risk. Having several million dollars to their name but investing exclusively in Money Market funds might speak to a slight disconnect between someone’s ability and willingness to take risk. A client’s ability to take risk relates to their current financial situation, future cash flow needs, and desired use of their investment proceeds. By combining the willingness to take risk with individual circumstances, a clearer picture of an investor risk profile is developed.
As advisors, we weigh an individual’s risk profile against our expectations for returns given macroeconomic and market conditions and shift portfolio allocations as risk and return expectations change. In the process of reconciling willingness and ability to take risk, we engage in dialogues with our clients to educate both them and us. The previously mentioned millionaire may have legitimate and valid reasons to hold a long term cash allocation. On the other hand, it may be that they are intimidated or uninformed of the benefits of a long term asset allocation strategy. Our job is to both teach and learn and ultimately make the best decisions for achieving a client’s long term financial goals.
www.summitcreekcapital.com • 208.928.7500 • firstname.lastname@example.org Disclaimer: All material presented herein is believed to be reliable but we cannot attest to its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us for the purchase or sale of any securities.
Do you recall the 2008 American presidentialelection? Volatile times, right? Good thing itonly comes around every four years, or we’dbe inun...