Daniel Needham, Morningstar’s Chief Investment Officer, has always highlighted the issues of conflating volatility with risk.
Way back in 2014, at the Morningstar Investment Conference in Chicago, Needham emphasized that many investment products focus on back-tested data, which shows past returns, and historical volatility to assess their level of risk. He analysed the correlation between historical volatility and forward losses across both bonds and equities over 10 years, and ended up with a negative correlation in 57% of cases, meaning that the two factors normally have a weak relationship.
Volatility does a pretty rubbish job at predicting losses. The fact it’s used so widely in this industry is quite puzzling.
He later stressed on the same issue.
Volatility has been industry shorthand for risk for quite a long time and it has not done a very good job of predicting the risk that matters to investors, which is losses.
In 2015, at the Morningstar Investment Conference in London, he once again reiterated that fact.
Volatility is viewed as risk, but I don't think that is actually a very good measure of risk. Risk is losing money and it’s losing money that you can't make back.
Now that markets across the globe are in an upheaval, Daniel Needham once again cautions investors. Read his views below.
- Market volatility is one of the most reliable things that you can predict.
You don't know what prices are going to do next month or the next year. The one thing we know is that prices are going to move around, and what we see is that prices often move around more than fundamentals, more than the underlying cash flows. So volatility should not scare you. In fact, you should be prepared for it. It comes with the terrain.
- Don't overreact and sell stocks when they're down or sell shares when they're down.
You'll have volatile periods where market prices will fall a lot, where stocks' share prices will fall, and maybe even residential property prices will fall. Naturally, people get scared. Because people feel the pain of losses more than they enjoy the pleasure of gains.
It's really important during periods of market volatility that you don't overreact, that you don't sell out your investment at the bottom. That's the worst thing that people can do. Our research shows that those that sell out at the bottom and then buy back in, say a year later when they feel more comfortable, do much worse than those that stay invested.
- Be prepared for the periods of market volatility by buying assets that you think are worth more than the price that you're paying for them.
At times, that means being willing to hold more cash. We view market volatility as an investment opportunity. Warren Buffett always says that he likes his stocks the way he likes his socks: on sale. So, often market volatility means lower prices.
It's a funny thing that in the stock market or the share market, people actually want more of something when the price goes up, and they want less of something when the price goes down. We think that's exactly the opposite of how you should think about it. So, generally when prices fall, it means you're able to buy stocks or shares, fractional ownerships of companies, at better prices. We view it as a positive, not a negative.
So we prepare for the volatility by demanding good prices before we invest, and that allows us to have capital or cash available to take advantage of the market opportunity.
Our view is that when we have periods of market volatility or where prices fall, it's often a time where you should be adding more to your investments rather than taking them away.
- The most important thing could be to actually not do anything.
Talk to your financial adviser or your financial planner and really stick to the plan. That's what the plan's there for. In the short term, markets are going to move around a lot, and it's very important that you take a long-term approach to investing.
