It seems that every week there’s another public company asking for government financial assistance. They are seldom of the comforting kind. While we know logically that the media prefers a storey that is bad compared to a good news storey and often some of the bad news is hear say and exagerated. The fact is that the financial markets are currently digesting a great deal of news – some of it good and some of it bad - and this has led to the current situation of increased volatility and a degree of turmoil in specific markets.
With all this turmoil many clients have been wondering whether their investment strategies remain sensible and sustainable. To address this issue, in this client letter we look at the issues of volatility, diversification and time as they relate to investment strategies.
The first issue is volatility. By this we mean how much prices of assets move around over time. When they move around a lot over a short period of time it is a period of high volatility. Investors tend to be most concerned about volatility when prices are falling. Then tend to be more relaxed (or even bold) when prices rise quickly. Because cash moves around very little – it is easy to predict from one day to the next what a cash investment will be worth – it is considered a low volatility asset class. Because shares can move around a great deal – as they have been doing lately – it is very difficult to predict what they will be worth from one day to the next. The cause of this volatility is news. When there is news that has the potential to change expected company earnings and the like then the price of the company’s shares can change rapidly. An example of this would be whether an economy was about to go into recession, as evidence from the US is suggesting might be the case in that country. This causes the outlook for corporate profits dependent on the US economy to fall, and when corporate profits fall, so do share prices.
For much of the current decade, volatility of financial markets has been historically low. Investors were rewarded for holding risky assets as if they weren’t risky at all. Under these circumstances, it was easy for some investors to think the good times would last forever. Now normal higher volatility has returned and this brings us to our second point: Volatility can be lessened (but not eliminated) through diversification of assets.
By diversification we mean the holding of a variety of different asset classes and individual securities. Each of these asset classes have different drivers that lead to the asset class having a positive return over time. For cash, these drivers are official interest rates, which are driven in turn by economic growth and inflation. In the current period, cash rates have risen in Australia (strong economic growth and higher inflation). This is good for some investors – those who are savers and have no debt – but not so good for borrowers such as homeowners with mortgages and investors with gearing strategies. For shares the drivers are economic growth, the cost of borrowing and the share of the economy going to corporate profits. Owners of all the different asset classes are rewarded at different times of the investment cycle. By holding a selection of asset classes investors have some insurance against the bad times.
The third issue is time. While financial markets can get rocked by short term news events, given enough time they tend to generate the sorts of returns we expect them to. This is why your investment time frame is so important and is generally tied to the level of volatility you are comfortable with. A simple way to think about your investment time frame is that you are invested from the moment you receive your money until you need to spend your money. Generally speaking, the shorter the time frame, the more certain you want the return to be. The longer the time frame the greater the volatility you can take on because the chances of having a higher return are greater. We want you to have your financial assets grow until you need them.
We hope that our discussion on these three key themes of investing – volatility, diversification and time – have gone some way to alleviate some of the worry you may be feeling at this time. Rest assured that we are here to assist you in whatever way we can. Please feel free to call or contact us whenever you feel the need.
