Don’t let volatility blow you off course

As investors, it’s human nature to get caught up in the daily noise of why markets are rising and falling.

As investors, it’s human nature to get caught up in the daily noise of why markets are rising and falling.

Volatility is always a fact of life on financial markets, but this year it’s been unprecedented. That’s not surprising, given what’s going on in the world; the list of factors continually driving all markets at the moment is pretty extensive.

The most obvious factor is the global impacts stemming from the COVID-19 pandemic, but there’s also the fallout from escalating geopolitical and trade tensions between China, the US and other countries including Australia.

Then there’s the volatility being spurred by the looming US presidential election, the still-unresolved Brexit program, and the flow-on effects on markets being caused by erratic commodity price movements, particularly the big swings in oil prices of late.

Last but not least are the market ripples constantly being triggered by the volatile daily price movements of the world’s largest conglomerates, many of which happen to be US-domiciled technology companies.

That partly explains why the Nasdaq Stock Exchange late last month launched a new index to measure sharemarket volatility.

The Nasdaq-100 Volatility Index (VOLQ) was created to give professional traders a way to gauge expected market volatility by using the prices of Nasdaq company options contracts due to expire in four weeks’ time. Traders can then use futures contracts to buy and sell the expected forward market volatility that has been calculated on the VOLQ.

If this sounds extremely technical, you’re absolutely right. It’s strictly for the professionals.

Trading based on expected financial markets volatility is nothing new, and the VOLQ joins a list of other volatility indexes that traders have been using for years.

Best known among them is the Volatility Index (VIX), often referred to as “the fear gauge”. The VIX measures the implied volatility of the S&P 500 index over the next 30 days, based on the trading prices of index options.

The Australian S&P/ASX 200 VIX Index essentially does the same thing, as do VIX-like indexes on other developed markets and regions, including the Euro Stoxx 50 Volatility Index in Europe.

The CBOE Skew Index is a volatility indicator that tracks options trading on the Chicago Board Options Exchange, and is used as a pointer to so-called “Black Swan” events — difficult to predict situations that have the potential to trigger a market crash.

When there’s more buying of downside protection options, the Skew indicates that traders are covering off their positions against a potential market correction.

Although market volatility is ever present, some companies — because of either the nature of their industry, the state of their ­operations or other external influences — often experience higher volatility than others. Listed companies with low volatility historically have achieved better risk-adjusted returns than those with higher volatility.

As such, a growing number of investors and financial advisers are using exchange traded funds and managed funds that have been designed to reduce the impacts from broad market gyrations. These minimum volatility funds are aimed at investors wanting a less volatile equity return ­experience with a degree of downside market protection while maintaining the ability to participate in the upside potential of the broad equity market.

A factor-based managed fund or ETF focused on minimising the impact of market volatility on a portfolio actively filters out the most volatile companies, with the objective of providing investors with greater stability over time.

As investors, it’s human nature to get caught up in the daily noise of why markets are rising and falling. Big falls, in particular, generally create panic and often fuel extended periods of heavy selling.

Even now, in a period when media coverage is dominated by events that have very uncertain outcomes, market volatility indicators are pointing to greater short-term instability.

The key is to switch off the daily market noise and to focus on your long-term investment goals.

Historical markets data shows that even though major events such as the Asian financial crisis, dotcom crash and global ­financial crisis resulted in sharp downturns, over the long term markets have delivered strong growth.

A $10,000 investment made into Australian shares in 1990 would have achieved an 8.9 per cent total return per annum over 30 years and, with the reinvestment of all distributions, grown to $130,457 by June 30, 2020.

Over the same time frame and using the same strategy, a $10,000 investment into the broad US market would have delivered a 10.3 per cent per annum return, and now be worth $186,799.

Successful investing revolves around having a well-planned and diversified strategy that’s aligned to your specific goals, and the discipline and resolve to stay the course, even during the most volatile investment times.

Tony Kaye is senior personal finance writer with Vanguard Investments Australia.

www.vanguard.com.au