A Survival Kit For Managing Stock Market Volatility

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by: Stockopedia

After a strong start to the year, we've had a few days of downward pressure on prices that was perhaps inevitable in some ways.

Over the past two years, UK shares have been flying. In fact, since the nadir of the financial crisis in 2009, the FTSE 100 has risen by a nice round 100 percent. But there have been a few corrections along the way. So you could argue that a seven percent fall like we've seen over the past week shouldn't have been entirely unexpected.

But even so, that doesn't mean that a sudden pullback is easy to deal with. For some of us, a fall in prices is a buying opportunity. If you'd done that after the EU referendum, you'd have caught the start of a two-year bull run. But for others, a sea of red across a portfolio, and the uncertainty of what might come next, is really worrying. When faced with blood curdling headlines (like these below), it's no surprise that even a modest wobble can spark a panic.

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Graham Neary did a great assessment of the price action this week - ably assisted by some brilliant contributions from the Stockopedia community. You can find that here. But on a more general note, we've sifted through some of our most popular 'correction' articles to bring some updated sanity to all this uncertainty…

1. Face up to volatility

One of the interesting features about the recent pressure on prices is the lack of a clear cause. Some commentary points to concerns over the possibility of rising interest rates in the U.S., together with rising bond yields.

Whatever it is, research into these sorts of turbulent spells in equity markets shows that volatility caused by uncertainty can become a vicious circle.

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Some of the most influential work on this subject was done by Robert Haugen (above), who was a quantitative finance professor that spent a lot of time looking at the effects of market volatility. One of his findings was that volatility begets volatility, which in turn makes markets excessively volatile - prices literally freak out.

To combat this, it's worth thinking about your own time frames, diversification and risk appetite for investing in the stock market. Can you live with inevitable periods of volatility?

Warren Buffett once famously said: "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years." In other words, the stock market is particularly powerful when used as a long-term compounding machine. If you accept this then it's possible to trade less, and incur fewer costs. Indeed, you could simply switch off from the periodic volatility by ignoring the market completely. Or you could see it as an opportunity - see point 2...

2. Falling prices can be an opportunity

Value investors have had an increasingly difficult time in the years since the financial crisis. Well-known U.S. fund managers like Jeremy Grantham (GMO) and Howard Marks (Oaktree) have written about this at length. For them, a high single-figure correction won't be enough to find real value in the market. But the point is that lower prices can be an opportunity for contrarians - especially for individual investors who can move fast.

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This is easy to explain using Warren Buffett's 1997 letter to Berkshire Hathaway shareholders. In it, he pointed out that net savers during the following five years ought to be hoping for a lower stock market, rather than a higher one. Yet for the most part, investors are elated when stock prices rise and depressed when they fall - a reaction that makes no sense.

Buffett's point was that only those selling shares in the near future should be happy to see markets rise, while everyone else should be happy to see prices lower.

For contrarian value investors, the hunting ground for opportunities in a correction is in high-quality stocks that have been pulled down by the broad market trend. Stocks with a combination of high Quality and attractive Value (but poor Momentum) are classified as Contrarian in Stockopedia's StockRank Styles.

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3. Manage your instincts - and don't panic!

There are hundreds of cognitive errors and emotional pitfalls that can lead investors into poor reasoning and bad decision making. In a crisis, it is fear of financial loss and future uncertainty that's likely to prevail.

In this case, the natural instinct may well be to take some kind of action to wrest back a sense of control. But this could be a big mistake.

Action Bias is the tendency for humans to think they can improve a situation by taking action. It could be diving to save a penalty kick in football, changing queues at a supermarket checkout, taking an alternative route on a congested road or trading shares in a market correction. This instinctive desire to take action gives us a sense of control, yet the outcome is likely to be the same or very possibly worse.

For investors, the trouble with Action Bias is that it leads to potentially unnecessary trading and all the associated spreads, commissions, tax and trading costs that involves. Doing nothing may make more sense depending on your circumstances. Either way, without a plan or checklist (see point 4), bad decision making caused by natural instincts like Action Bias are a risk.

4. If you haven't got a plan, make one

Psychologists have shown that, as humans, we're prone to having an 'illusion of courage' about how we'll act in difficult situations. In other words, when we're cool, calm and collected, we're pretty bad at imagining how we'll react when all hell is breaking loose.

This is known as the 'empathy gap' and it's why respected commentators like Charlie Munger, Mohnish Pabrai and Michael Mauboussin are taken seriously when they talk about pre-commitment and checklists.

Pre-committing to a plan can be used everywhere in investing. It can help in sticking to strategy rules and being properly diversified. But it's when things get difficult that a plan is most important. That's because our natural instincts can easily turn a bad situation into a catastrophe. The trick is to make a dispassionate plan before the crisis happens.

In his new book Think & Trade Like a Champion, Mark Minervini puts it like this: "Without a plan, you can only rationalize. Often you will tell yourself to be patient when you should be selling, or you may panic during a natural pullback and then miss out on a huge stock move."

5. Strive for a diversified portfolio to protect from the worst - all the time

There's no doubt that highly concentrated portfolios can work well if you are very sure (and correct) in your analysis. But it's also true that diversification can smooth out the kind of unique risk you get from focused, high conviction holdings. The trouble is that most investors don't do this. Research has long shown that for a variety of reasons, most investors only have a handful of holdings.

So how many is enough? When we've looked at this before - using portfolios of high StockRank shares - we've found that the divergence in returns narrows a lot when you increase the number of shares from eight to 25. At that higher number, we found that portfolios were more likely to get a satisfactory return.

Diversification, of course, isn't just about safety in numbers. It's about broad sector exposure, foreign market (or revenue) exposure and market-cap exposure.

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Be careful out there

It remains to be seen whether this latest stock market setback - something we haven't seen since mid-2016 - turns out to be anything more severe. But either way, there's never a bad time for a portfolio health check. The pressure on prices is a reminder of how important it is to have an overall investment plan, particularly in times of stress. For some, these moments present opportunities, while for others they are a time to keep calm and perhaps step away from the computer - and definitely ignore the blood-curdling headlines.