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Volatility is the bane and the essence of the market.
Without price volatility, there would be nothing but fixed income returns. The knack, for the investor, comes in accepting that volatility is in the blood of capital markets and then coping with it.
That gets tough when markets go into death spiral mode. Fear replaces bargain hunting and panic deepens. On Feb. 27, markets headed for the abyss when the Shanghai composite index fell 9 per cent in just one day - the worst drop in a decade. That triggered a 364.33 point drop to 13,040.11 in the S&P/TSX composite, a loss of 2.7 per cent. In the U.S., the Dow Jones industrial average dropped a stunning 546 points when computer systems crashed, then closed with the day’s loss totalling 416.02 points to 12,216.24, a 3.3-per-cent drop.
Markets swoon more often than statisticians say they should. The normal bell curve predicts that a drop of 22.6 per cent, which happened to the Dow Jones industrial average on Oct. 19, 1987, should occur only once every ten trillion years, according to Didier Sornette, author of Why Stock Markets Crash (Princeton, 2003). "Amplitude of more than 5 per cent should never be seen in our limited history. Events like that of Oct., 1987, tell us that the market can deviate from the norm."
The reason bungee-like moves in the markets happen more often than the curve suggests they should comes down to the people behind the moves - it’s market psychology. People react to each other and produce collective euphoria in bubbles and collective panic in crashes. "It is enhanced by the era of globalization," says Patricia Croft, chief economist for Phillips Hager & North Ltd. in Toronto. "What that means is that what happened in China produced a ripple effect that was rapid and broad. It is the model for what we can expect in future."
The antidote to getting hurt by crashes is to adopt defensive and opportunistic strategies. They range from holding cash, to investing in asset classes that have relatively low volatility, to buying assets that move opposite to market trends. And, of course, it is useful to hold cash precisely in order to buy when the masses panic.
In Canada, volatility varies by asset class. The least volatile to hold is financial services, since it has the most stable earnings. The most volatile is resources, which are highly cyclical, Ms. Croft notes. In between are consumer staples and industrial products, in that order. Large caps are less volatile than small caps and dividend paying stocks have intrinsic support in comparison to those that do not distribute some of their cash flow, Ms. Croft says.
Diversification into several asset classes reduces portfolio volatility. Adding bonds to a portfolio provides a counterweight to stock selloffs. Barclay’s iShares Canadian Universal Bond ETF, which emulates the SC Universe Bond Total Return Index, produced modest gains in the 10 days following the Feb. 27 equity market crash. The total gain, about 3 per cent, offset the S&P/TSX drop.
One can also buy into a bear fund that goes up when markets go down. For example, the Horizons BetaPro S&P/TSX 60 Bear Plus Fund gained 5 per cent in the days following the four trading days following the Feb. 27 crash, only to decline once a market recovery was under way.
The question inevitably arises - how far should one hedge away volatility?
On a short-run basis, the answer is rather simple. If a portfolio is all in cash when markets slump, there will be no loss in asset value. But carrying a pure cash portfolio or a pure bond portfolio for periods of many years tends to mean a major opportunity loss in comparison to what equities may have been able to generate.
The principle of fate summed up in Murphy’s Law, "If anything can go wrong, it will," has a corollary: "Murphy was an optimist." In finance, you can read that to mean that as strategies become popular, they tend to be competed away and lose their edge. Then they become nothing more than ways to generate fees or to lose money.
But, Ms. Croft says there is one hedge that cannot fail: diversification into all markets. There is no counterhedge or system of exploitation that can eliminate the value of having money in all major capital markets. "Diversification is an important tenet in global asset management, but the degree of correlation among markets varies over time," Ms. Croft notes. Her advice: "Use a global balanced fund to get a mix of equity and debt in various global markets and leave it to the experts to vary asset allocations."
You also need to consider style and direction diversification, says Brad Bondy, director of research for Genus Capital Management Inc. in Vancouver. "The problem is that the outcome is very sensitive to your assumptions. For the long term investor, style is not important. One style merges into another. The important thing is to make an asset allocation and stick with it." A value strategy, he notes, will have less volatility than a growth strategy, and some of the time, growth stocks will beat value stocks, just as bonds will sometimes beat stocks. "Blend the two and that will even out some of the bumps."
Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.