For the first time in a long time investors faced an increase in volatility this week that had many on edge. It’s been years since we’ve seen 300 point daily swings in the Toronto stock market, the last time being the European debt crisis of 2011.
Volatility, in an academic sense, measures the size of ups and downs in the market. It’s just a number, and in itself is not what will make or break an investment plan. Most plans are conceived with the ability to withstand volatility, either by taking some direct action, like getting out of the way in the case of the Growth and Income Portfolios, or riding it out in the case of passive index investors. So if volatility doesn’t matter, why does it matter?
The real danger of volatility is its effect on our emotions. When we see positive volatility, like a surprise overnight gain, investors feel good about it, but not necessarily great. On the other hand, when negative volatility appears, research pioneered by Daniel Kahneman and Amos Tversky suggests that losses feel twice as powerful, psychologically, as gains. This emotional loss aversion brought on by volatility is what causes otherwise rational investors to abandon well-laid plans. Therein lies the danger.
For example, some investors who say they can handle a 10% loss may lose faith in a great strategy when they see they’re down only 5%, while others who say they can handle only a 10% loss keep holding a losing investment even when it drops by more. When expectations and outcomes don’t match up, plans are unwound and investors become unhappy with results.
That’s why as a Portfolio Manager, one of my most important jobs is to set appropriate expectations for volatility, and help investors understand where they fit in the volatility comfort zone. When we have that rational discussion, we build reasonable expectations, ensuring our plan longevity and ultimate success.
The true test for investors then is not choosing an investment strategy that deals better or worse with volatility; it’s choosing an investment strategy that you can follow no matter what volatility comes your way. For most, less is better.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.