Headlines about large rises and falls in the world's sharemarkets can frighten and confuse investors. In recent times we have seen far more than the normal amount of sharemarket volatility and this has led to a great deal of media coverage and a heightened degree of investor anxiety.
The wild swings in stockmarkets began in the second half of September when the US sharemarket saw daily movements in either direction of more than 3% on almost half the trading days. Financial failures were followed by bail-outs and rescue plans and progress of the Federal Government's "Troubled Asset Relief Program" rescue was made in fits and starts. Investors watched the collapse of Lehman Brothers and Washington Mutual in the US and the rescue of American Insurance Group, Bradford and Bingley, Fortis, and HBOS. Each Government intervention gave hope that the worst had passed and encouraged fresh buying before new concerns arose.
Extreme Risk Aversion in October
The concerns intensified in October and some tumultuous days were seen in the global markets as the banking crisis spread. Dramatic reductions in official interest rates started with the Reserve Bank of Australia which slashed a full 1% off short term interest rates in one move. Most other central banks (including the Reserve Bank of New Zealand) made similar moves.
The average daily swing in the US sharemarket increased and we saw moves of more than 3% in either direction on two thirds of the trading days. The market even had two days when the upswings were greater than 10%.
During October a key measure of daily volatility, the VIX index in the United States, was at levels consistent with extreme risk aversion. The VIX is a measure obtained from the prices of index options traded on the Chicago Board of Exchange. It usually trades at a level around 10 and 15 with the occasional increase to 40 during periods of turmoil. In October it hit levels above 80.
Volatility Can Come and Go
The previous period of high volatility was between 1997 and 2003 when the technology boom and bust, the accounting scandals and the shock of terrorism played havoc with markets. Following this there was a period of relative calm from 2004 till 2006 which shows that volatility eventually fades.
Periods of high volatility are clearly associated with heightened pessimism but are not necessarily the time to sell shares. Investors' concerns can feed on themselves and lead to markets overshooting on the downside. For example, the current crisis has been characterised by liquidity concerns about financial institutions, causing funding to dry up for these firms and making the situation more severe. More than ever, the pessimism has become self-fulfilling and has driven share prices lower and lower. Investors need to be mindful that the current crisis will not continue forever and once calm has been restored, the prices of shares are likely to recover.
The Challenges for Investors
Of course, the challenge is that there are few useful indicators for when the crisis will end and decisions about how to implement an investment plan are difficult to make in this environment. If investors accept that picking the turning points in the markets is impossible, then a strategy of gradually investing over a period of time makes sense. Managed funds give investors the ability to add to their portfolios in small amounts and avoid having to make a large commitment to the market at one time.
Also, using a fund manager who has the flexibility to select the most attractive securities can give investors confidence in uncertain times. If fund managers are able to be more selective they may be able to focus on quality companies whose share prices have been unduly affected by market sentiment. Stronger returns may result from the recoveries in these "oversold" shares.
In times of extreme volatility, investors need to remember that their investment time horizons extend well beyond any particular market cycle and short-term market movements can create opportunities. They should also be aware that volatility comes and goes and periods of relative calm can be just around the corner.