The domestic equity market has demonstrated remarkable volatility in the last few days. The rapid price fluctuation on locally listed stocks is indicative of the impact of global economic uncertainty, and is echoed on international markets too. Asset mana
Volatility (www.investorwords.com) is defined as the rate at which the price of a share moves up and down. If the price of a stock moves up and down rapidly over short time periods, it has high volatility. If the price almost never changes, it has low volatility. Levels of volatility vary between markets and shares, but tend to increase during times of uncertainty.
A quick look at the major shares and indices on the local stock market confirms that we are definitely trading in uncertain times.
Market uncertainty makes for choppy investment conditions
There are a number of issues contributing to market uncertainty at the moment. Perhaps the biggest international issue is that of sub-prime lending in the United States. For those of you who don't know, sub-prime lending involves the extension of credit to higher risk individuals.
Extending credit to high risk borrowers is not a problem as long as asset prices remain buoyant. The lender can always recover its money by seizing and re-selling the asset over which the loan was made. But when asset prices come under pressure (as with house prices in the US economy) a situation develops where the debt is no longer adequately covered by the underlying assets. And the problem quickly spirals out of control.
Worrying development in the domestic economy include the current upswing in the interest rate cycle which has seen the prime lending rate shoot up to 13%, with a further 50 basis point hike expected later this month. Coupled with interest rates we have rampant food and oil price inflation, high levels of household debt, a soaring current account deficit and a tougher credit environment. All of these factors contribute to an understandably shaky stock market.
Time smoothes out the peaks and troughs
How should the average investor approach the resultant volatility?
Well, an interesting way to look at the topic is to consider the graph of the FTSE/JSE All Share Index. Most financial websites provide applications which allow you to adjust the time period on the graph. A better understanding of the impact of volatility on investment performance can be gained by comparing a 5-year graph of the All Share Index with a 3-month graph.
Notice the difference? Most notably the 5-year graph is much smoother than the 3-month graph. And the longer the term over which you view the data, the smoother the graph becomes. This comparison reveals one of the truths of long-term stock market investing. Time in the market smoothes the impact of volatility on investment return.
It is important to realise that general volatility levels contained in the 5-year graph are no different to those in the 3-month graph. The difference is that over time, the volatility matters less and less. The return in the market is smoothed over time.
One place where burying your talents actually works
Most of you will be familiar with the New Testament parable about a wealthy man who entrusts an amount of gold to each of three servants before embarking on a long business trip. He commands them to take care of the gold for his return.
Upon his return he calls each of the servants to account for the monies he had entrusted to them. Two of the servants had industriously put the gold to work and were able to return double the amount they had initially received. The master rewarded them for their efforts. The third servant simply buried the gold and returned the exact amount he had received. Of course this lack of diligence was met with immediate censure.
The stock market is a totally different master. It tends not to reward the industrious servant who tries to maximise return by continually chopping and changing shares. Instead the market rewards the investor who buries his money in the market. Those who tie their funds up in a carefully selected portfolio of stocks and dig them up again in twenty years are rewarded handsomely indeed.
Timing is a practice destined for failure
The lesson to be learned is simple. Attempts to time the stock markets are generally futile. The best equity investment strategy remains to invest for the long-term to allow you capital to ride out the many and varied market storms and provide you with an average compounded return over a number of years.
Editor's thoughts:
Balancing ones investment portfolio between the various asset classes is difficult at the best of times. The process is exacerbated when global equity markets enter phases of extreme volatility. Share prices in 'blue chip' companies can jump by as much as four percent in a single day's trade a frightening reality when we consider that average long-term equity market returns are closer to the 15% per annum mark. Do South African investors react too hastily to short-term market fluctuations? Send your comments to gareth@fanews.co.za
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