Did you pass the volatility test?
Investors tend to think of market volatility in terms of declines. Properly defined, volatility is a measure of the swings or “deviation” in returns – both up and down.
Over the past six months, we’ve seen textbook cases of both.
Remember the fourth quarter of 2018: after a prolonged period of relative calm, global stock markets turned sharply negative, with the S&P/TSX Composite Index falling 10.89% and the S&P 500 Index down 13.97%. Equity market performance for the month of December was the worst in history. Among major asset classes, only cash and bonds finished the year with a positive return.
But what happened next?
During the first two months of 2019, global markets snapped back. At the time of writing, they have largely recovered the losses suffered during the fourth quarter.
Although negative volatility is unnerving, it can be a test of the strength of a portfolio and the temperament of an investor. Studies abound showing the average investor consistently performs worse than the overall market because they change course at precisely the wrong times. That is, selling on fear when the market is down, and buying on fear of missing out when the market is roaring.
During the fourth quarter market sell-off, our Investment Committee met more frequently to review our strategy. Are we positioned right? Do we understand and are we comfortable with the risk in our portfolio? We consulted with independent specialist money managers in each asset class and reviewed macro data with our economist. We also observed the portfolio closely to see that it responded the way we expected.
We also used the sell-off as an opportunity to put some of our cash to work at lower valuations – as did some of our managers. As one of our independent equity managers is fond of saying, “Volatility is the friend of the investor who knows the value of a business and the enemy of one who does not.” Deploying cash when good assets are on sale helps to set the portfolio up for outperformance over the long-term – as opposed to standing pat or, worse, selling into the decline.
This short period of volatility was a live test: Did our strategy hold up? Did the portfolio behave as we expected? Has anything changed in our medium to long-term outlook? Although we all would have preferred not to see any decline in value, we satisfied ourselves that it did; the Newport Balanced Fund was down just 3.67% for the fourth quarter and finished the year off just -0.86%. It has also largely recovered along with the markets, so we successfully protected capital on the downside and have participated in the rebound.
The experience is a reminder of how unpredictable markets can be in the short-term, the importance of having a sound plan, and sticking with it through interim market gyrations, as there will no doubt be more bouts of volatility. For those who do, patience is rewarded.
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