Riding out the volatility wave

Australian investors have had a wild ride over the past month.

According to the VIX Index, a useful index that forecasts the volatility of the US stock market, expectation of future volatility has more than doubled in the past month, rising from 15.2 per cent on July 15, 2007, to a high of 30.7 per cent on August 15.

These levels are the highest seen since March 2003, although they are still well below the high points reached in 1998 after the LTCM collapse and the Russian debt crisis, and in the early 2000s towards the end of the tech boom.

Cross sectional volatility — a measure of dispersion of equity returns across stocks in a market — has also ticked up in the last month, showing a substantial increase in dispersion across the stocks in the MSCI World index. Similar patterns have been observed across most major global equity markets.

In Australia, the local stock market has been down 7.7 per cent since the end of July 2007, only to rally by a whopping 4.6 per cent on August 20 (the day of writing) — the largest daily increase seen in the local market since October 29, 1997.

Alert but not alarmed

While these new levels of higher volatility are still somewhat below those observed in the early 2000s, they represent a significant shift away from the low volatility environment of the past four years.

It is tempting for many people to look at current volatility in the markets and decide to take their money out and wait to enter at a more advantageous time.

What these individuals may not realise, however, is that this type of behaviour is actually closer to speculating than investing — and could significantly dampen investment returns over the long haul.

Recently updated research by Russell shows that long-term investors need not worry unnecessarily about isolated incidents of market volatility.

Rather, investors should look to stay invested in the markets over the long-term and refrain from trying to time investments based on momentum or speculation.

The research highlights that the riskiest element in trying to time markets is the risk of being out of the market when it has bottomed out, when sentiment is at its most negative and potential future returns are at their greatest.

Market timers must be right twice: when they sell and when they buy. Timers tend to get out too early and get back in too late, so they miss the up markets before and after the fact.

Market timers will then usually have difficulty getting back in the market, because upward moves in the market tend to happen in accelerated bursts, which can be very easy to miss for investors not already invested.

Realities of investing

Most of us are familiar with the concept that ‘slow and steady wins the race’, which was so well illustrated in the famous Aesop fable, Tortoise and the Hare.

Many investors, however, find it difficult to incorporate this time honoured wisdom into their investment behaviour.

It is very easy and tempting to do away with patience and chase the next ‘hot’ investment.

However, the boring reality is that investors often gain better results by simply staying invested in the market over a long period of time.

If you follow the crowd and chase the latest sure thing, you could buy high and sell low — the absolute antithesis of sound investing.

Chart 1 (page 26, Money Management, August 30 2007 edition) shows that investing $10,000 in the ASX All Ordinaries in February 1980 and pursuing a ‘buy and hold’ strategy resulted in the original investment being worth $316,332 on July 31, 2007.

The chart shows the effects on the investment of missing the best performing months — the difference is quite substantial.

Russell’s calculations indicate that an investor who incorrectly attempted to time the market and missed the single best month over a 27-year period ended up with $272,313, almost 14 per cent less than the investor who pursued the ‘buy and hold’ strategy.

Investors who sat on the sidelines and missed the best 10 months over a 27-year period finished with just $102,948, 67 per cent less than one-third of the patient, ‘buy and hold’ investor’s end value.

Chart 2 (page 26, Money Management, August 30 2007 edition) demonstrates that the results are similar for global share markets, specifically for the United States. Russell’s analysis shows that incorrect investor decisions about when to be out of the market can prove very costly.

Clearly, time can be a better ally than timing. With a ‘buy and hold’ strategy, investors can leverage the power of compounding, which is the ability of invested money to make money.

Stop gambling and start winning

Russell’s view is that investors should hold a diversified portfolio of investments for an extended time horizon to meet their long-term investment objectives.

One of the ways to take the guesswork out of market timing is to use the time-tested approach known as dollar cost averaging.

This market entry strategy provides the opportunity to average out the ups and downs whereas investing a lump sum at one point in time takes on the more crucial dimension of market timing.

Dollar cost averaging is a strategy whereby the investor commits to invest a set dollar amount on a regular basis and sticks with this approach through up and down markets.

Four scenarios were set up to show how a disciplined investment strategy such as dollar cost averaging can not only help investors take advantage of market rallies but also limit losses during market downturns (see charts 3 and 4).

Dollar cost averaging induces the discipline of regular investing through good times as well as bad. It takes the emotion out of investing; the very emotions that drive market timers.

Like it or not, each one of us is practising an almost perfect form of dollar cost averaging: superannuation contributions.

In bull or bear market times we are still making regular dollar contributions to our superannuation fund.

In a bear market investors begin to worry about the performance of their superannuation investments. They overlook the fact that, because of lower fund unit prices, their regular dollar contributions have greater buying power, that is, investors receive more units for the same dollar contributions.

Because you’re buying more units when prices are lower and fewer units when prices are higher, the average cost of your units will be below the average market price of all the units. And when the markets eventually turn, those units purchased at bargain prices immediately yield capital gains.

Therein lies the beauty of dollar cost averaging. Russell examined the Australian and the US share markets and the results support the notion that time in the market is more important than market timing.

Charts 3 and 4 show that as investors increase their investment horizon, they markedly reduce the probability that they will experience negative returns.

Research shows that if investors increased their time in the Australian share market from one year to three years they reduced the probability that their investment would experience a negative return from over 19 per cent to just less than 1 per cent. The charts show that extending the investment horizon out further has an even stronger effect.

Russell research into US share market returns extends back to 1937.

Almost 31 per cent of one year periods displayed negative returns.

Market timers who randomly chose to invest for any given one-year period had an almost one in three chance of losing money.

However, patient investors who left their money in the market for an extended period of time turned the odds back in their favour.

The evidence is overwhelming: market timing is a risky strategy that rarely works.

Dollar cost averaging is a much more effective market-entry strategy for a number of differing market conditions, as it removes the emotion from investing that can lead to poor decisions.

Peter Gunning is chief investment officer Asia Pacific at Russell Investment Group .