In this world, nothing is certain, except death and taxes. » Words of Benjamin Franklin, former American President and one of the Founding Fathers of the United States. To this, let’s add this: today, nothing is more certain than the volatility of the stock markets. Yes, “learning to live with” will definitely be the expression on everyone’s lips in 2022…
My next columns will aim to better equip you so that you are ready to get through these turbulent periods, which are unpleasant, of course, but all in all normal.
Many wrongly associate volatility, yield and/or stock market crisis. Rather, volatility is the magnitude of the change in the price of a financial asset. When the markets are very volatile, strong increases and strong decreases of certain stocks will alternate. Volatility is not always synonymous with a market correction, which is usually defined when markets fall more than 10%.
What explains the recent volatility?
The current volatility is mainly due to the uncertainty caused by the start of the cycle of interest rate hikes by the world’s central banks in an attempt to curb rising inflation. These increases expected to counter inflation will increase borrowing costs for some businesses and should consequently curb economic expansion.
All this against the backdrop of tighter monetary policies — governments have stopped “printing money” — for the first time in two years. Stock markets are reacting because investors are currently reassessing the value of the assets they hold. You will have to get used to the idea that volatility will be more and more present as the cycles of rising rates materialize.
Living with the cycle of emotions
By better understanding the cycle of investor emotions, you are better equipped to react to them.
Decisions based on emotions can be expensive. Several car purchases are proof of that, right? Joking aside, as a consumer, you certainly go through a very rational selection process when the time comes to acquire many goods. You will wait for sales, or try to pay the lowest price, or get the best value for money. However, the data shows that investors are doing the opposite! They tend to buy when the markets are rising, therefore at higher prices, and do not take advantage of lower prices during pullbacks.
Theoretically, the “maximum-optimal-magic” opportunity is at the bottom of the stock cycle, when the majority of investors experience a sense of panic (“I think I’m going to sell, to lose less money”) and a desire for surrender (“I give up, I’ll never do it again”). The vast majority of savers wish, when the news is good, inspired by a wind of optimism, to buy more, thus doing so at a higher (and sometimes too) high price.
This explains why the average annual return of a mutual fund investor is lower than the benchmark index. Research by DALBAR shows that, over a 20-year period (ending December 31, 2020), the S&P 500 Index had an annual return of 7.47%, while the average investor earned 5.96 %. The conclusion of this study is that this lower return is mainly explained by the behavior of investors and the decisions they make during periods of market stress. If you do not master the cycle of emotions, be sure to seek professional support for the management of your portfolio.
Staying the course despite disruption
Rational consideration should be given to the fact that occasional market corrections help identify stocks that may have significantly exceeded their intrinsic value and provide opportunities for selective investors to purchase securities at more reasonable costs. You have to remember that, generally, the stock market reacts better than the bond market in a rising interest rate environment.
Keep a cool head and remember that corrections are not uncommon. Generally, stock markets experience a 10% decline, a healthy correction, two out of three years (source: Bloomberg). In the past, declines of 10% in the three months preceding and following rate hikes have been regularly observed. On average, stocks gain 7% in the six months following this first rate hike and 12% in subsequent months. So, although it may seem difficult at times, disciplined investors are rewarded.
In conclusion, if you are thinking of selling, tell yourself that it is on the contrary the time to buy! Next week, I will introduce you to the strategies of the rational investor. Until then, “hang on your toque” and remember that emotion is not the key in investing.