Articles

Living with Uncertainty

In volatile times like these (we seem to have triple-digit moves in the Dow every day or so, with the market down significantly since its April peak), it is completely natural for investors to have feelings of anxiety and fear, and even a feeling of powerlessness. The problem is that acting on these emotions can end up doing more harm than good.

The current increase in volatility is, at its core, an expression of increased uncertainty. Investors are newly worried about a multitude of issues, including the US and European debt loads, strains on financial institutions, and increased concerns about a possible new recession. This uncertainty is causing investors to apply a larger discount to risky assets, which drives their price down. Hence, US and international stocks, oil and industrial commodities, and commodity-related currencies like the Australian dollar are weakening significantly as investors sell these assets and seek the perceived safe haven of US Treasuries, Swiss francs, and gold.

The severity of the correction in risky assets is reminiscent of the 2008 financial crisis when the collapse of Lehman Brothers and the sub-prime mortgage debacle precipitated a global market downturn. This time, investors have shifted their focus from private-sector to public-sector debt. No one knows for sure what will happen next – this is the nature of risk. Hence, it’s good to recall the key points to an investment discipline which can make the current volatility more bearable:

Remember that markets are highly unpredictable. They frequently react in ways not predicted by the “experts.” As an example, the recent downgrade by Standard & Poor’s of the US credit rating actually led to a strengthening in Treasury bonds.
As Peter Lynch famously said, “When you sell in desperation, you always sell cheap.” While prices have certainly fallen (to reflect the increased level of uncertainty), this decline actually increases the going-forward expected return for stocks. While the media often focuses on how “investors are dumping stocks,” they regularly fail to point out that for every investor selling, there is another purchasing those assets at reduced prices. Those purchasing investors often have a longer-term perspective and an expectation of reaping good long-term returns.
Recoveries in the market can come just as quickly and violently as corrections. As an example, in March 2009 when market sentiment was much worse, the S&P 500 turned and put in seven consecutive quarters of gains totaling over 80%. This is not to suggest that a similar recovery is in the cards this time, but it is important to realize that selling at an inopportune time can take a paper loss and turn it into a permanent one.
It is important to remember the power of diversification. Although stocks have had a challenging time this year, fixed income markets have been strong. By spreading the risks, a well-diversified investment approach smoothes out the ride.
Also remember that markets and economies are different things. High sovereign debt levels can hamper economic growth, but lower economic growth rates do not necessarily result in lower equity returns. Again, global diversification mitigates risk in the continually changing world economy (for example, with emerging markets thriving as advanced economies struggle to address their public sector balance sheets).
No trend lasts forever. Just as intelligent investors temper their enthusiasm in good times, they also maintain a good dose of optimism in times like these. As in life, moderation is a good thing!

If you find yourself listening to financial media reports, you will notice one question that is often asked: “What should investors do now?” The answer is that if you have a well thought out plan and are well diversified (as you are), then most likely, nothing! This recognizes that at some point, value and an appetite for risk will re-awaken. For those who acknowledge their emotions and continue to execute their discipline, relief will eventually replace anxiety.