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So much volatility, what is an investor to do?

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Thursday August 25, 2011 at 9:00am

Although a daily report on the position of the FT100 index of UK shares is totally irrelevant to the long term investor, the media insist on relaying it in almost every news report at the moment.

Steve Forbes, publisher of US Forbes Magazine, makes an interesting point; “You make more money selling advice than following it. It’s one of the things we count on in the magazine business – along with the short memory of our readers.”

There is no doubt that big movements in stock markets (volatility) make investors nervous. At times like this it is as well to return to first principles so I thought it would be useful to look at what the present lurches in world markets mean in a rational way.

Markets work: There is a huge body of academic research that tells us that markets reflect all available information. Also it is not possible to consistently prosper by trying to outguess the market. The only factors moving markets are unanticipated future events. The current volatility is because future events have become more uncertain and hence more difficult to price by markets.

However once news is in the public domain it will already be factored into stock market prices. This means that no matter how well informed you are the market will already have beaten you to the news. This is why it is impossible to consistently make financial gain by trying to time or second guess the market. Having an investment strategy and sticking to it is the only way to consistently achieve the return the market owes investors for taking on risk.

Risk and return are related: that is we demand a higher return from investment in equity as we are exposed to a higher degree of financial risk. Clearly that return does not come in a straight line with a little more return each day and each week.

I’ve commented before on risk and return in An investment philosophy that will let you sleep at night. In reality the only way to look at return from an investment portfolio is to look over a longer period of time. Not 1 week or 1 month or even 1 year. It is much more sensible to look at returns over 3 years, 5 years and 10 years. For example our 100% low cost equity portfolio returned -22% in year to April 2008, +43% to April 2009 and +10% in year to April 2011. Over those three years this equated to an annualised return of 7.13% per annum. (Not dissimilar to the 10 year annualised return from the same portfolio). However if you had invested in 2008 and then sold you would have crystallised on a real loss and missed out on future gains.

Diversification is key. The vast majority of people do not hold 100% equity and hold at least some fixed interest. As equity values have fallen fixed interest prices have risen thus going some way to counteract the drops in equity values.

Another important point about diversification is to understand how it is defined. Holding a variety of asset classes is important (such as equity, fixed interest, property, and cash). However it is also important to ensure that the equity you hold is properly diversified. For example UK stock markets compose around 7% of global equity markets by market capitalisation. Hence holding only UK quoted stocks is not very diversified based on this definition. Unlike our globally diversified equity portfolio discussed above making 7% per annum over the last 10 years, the FT100 has actually made a negative return over the same period. The reason being one portfolio is fully diversified, the other is not.

For more in diversification read Investment diversity today is all about the global economy.

Behaviour biases or emotion can overwhelm reason. The same part of the brain processes the effects of financial losses as processes our response to mortal danger. This can lead us to avoid financial risks once we have suffered a loss. It can also make us take additional risk once risk has occurred. Neither behaviours are rational but it can help explain why many investors will sell out of investments when prices fall, that is perversely when equities become cheaper. The same investors will most likely buy when everyone else is buying, that is when equities become more expensive. Don’t forget that for every investor selling there has to be another investor buying.

So what is an investor to do? Nick Murray (a highly respected American commentator) said “At the end of our investing lifetime it won’t matter what your funds did, it’ll matter what you did. And what you did will be a pure function of the quality of advice you got – from one caring competent advisor, and not from any number of newspapers and magazines”.

And so on that note my advice is to hold a properly diversified portfolio of investments, reduce expenses, minimise taxes and maintain a strong buy and hold discipline. Work with an advisor who will make you aware of the real investor biases and don’t allow them to cloud your judgement.

Andy Parker BSc FCA APFS Chartered Accountant Chartered Financial Planner.

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Parker Chartered Accountants and Financial Advisors is the trading name for PLW Advisors Ltd (Registered No. 10396831), and Parker Financial Planning LLP (Registered No. OC347027). Parker Financial Planning LLP is authorised and regulated by the Financial Conduct Authority. All companies are registered in England and Wales – registered office contact details here