The volatility that unnerves some can present significant opportunities for those who can be nimble and focused.
Smart Investor: Discipline does not mean inaction (afr.com)
Markets are driven by emotional investors trying to predict the future which is inherently uncertain.
The conventional wisdom is that maintaining your discipline around a long-term strategy is the cornerstone of a successful investment strategy. Whether you are a professional investor or new to the market, everyone is encouraged to stay calm and focus on their risk profile, long-term goals and stay the course on the recommended asset allocation.
But investing is an emotional vocation and there is a significant body of academic work dedicated to the human behavioural biases that can lead to sub-optimal investment decisions.
Fear of missing out draws investors into overstretched markets, which can be exacerbated by people searching only for data that confirms their views. Working with limited information or on a part-time basis can also be an issue, and investors have an uncanny ability to be overconfident and extrapolate prevailing trends.
The emotion of making a mistake can be debilitating, leading investors to hang on to poor investment decisions, hoping for a miracle to avoid crystallising losses.
Markets are constantly moving and the volatility that unnerves some can present significant opportunities for those who can be nimble and focused. Although professional investors spend years perfecting their processes and trying to bring dispassion to their investment calls, private investors with a clear head and disciplined strategy can look for opportunistic short-run strategies to pick up returns.
Driven by rising inflationary expectations, central bank hawkishness and the Russian invasion of Ukraine, markets were incredibly volatile in the first quarter of this year. Energy prices rallied hard, bond yields rose rapidly and equity markets fell into correction territory.
German equities significantly underperformed other European markets, but that relative underperformance has closed quickly. The Chinese market was also weak on fears about lockdowns and the regulatory clampdown on technology stocks but appeared oversold and has rallied strongly.
Short-term volatility can often make changes in longer-term trends more difficult for investors to see. Factors such as globalisation, imported deflation and quantitative easing are reversing and will have profound impacts on the economy and many asset classes. Long-term asset allocations probably need to change, which can be difficult in the heat of the moment.
Future market volatility
The rise of inflationary expectations will probably play a significant role in shaping the future path of markets over the balance of 2022. Central banks are leaning in significantly with both commentary and actions.
The move back towards a more normal level of cash rates and the debate about the scale and speed of quantitative tightening (reducing the size of central bank balance sheets) will add volatility to market pricing over the months ahead.
Inflation releases will probably peak in the next few months and investors will struggle to look through headline US CPI releases in the region of 8 per cent to 9 per cent. Long bonds remain in negative real yield territory and markets will probably remain volatile as inflation flattens out, bond yields find a natural trading range and central banks feel comfortable that they have moved to a new equilibrium. Long-term equity market valuations will continue to be questioned and the sector leadership within equity markets will also probably be volatile.
It is clear that in a world where many of the long-term tailwinds are reversing, cross-sectional volatility is likely to increase. This means that global investors will need to be more dynamic to capture both the long-term trend changes and the short-run mispricing between relative sectors. It will be a constant battle second-guessing if markets will mean revert or continue to trend.
Big increases in volatility and fears over significant market declines can be unnerving for private investors, often leading many to avoid making investment decisions or driving them in to knee-jerk mistakes. Although the reliance on a long-term investment strategy is critical, this is not an invitation to be completely static. Markets are dynamic and will probably still exhibit the real human emotions of euphoria and despair. And there lies the opportunity.
James Wright is a founding partner of Sayers, a modern advisory and investment business.