Flying through turbulence – Market volatility

On September 19 en route from Atlanta to Fort Lauren, Delta Airlines Flight 2352 dropped, unannounced, out of the sky.

According to media reports, the Boeing 757 “plunged” to an altitude of “10,000 feet from 39,000 feet in seven minutes”, allegedly sending passengers into panic mode.

In a breathless post-flight interview, Harris Dewoskin, a Delta 2352 passenger, told press the rapid descent triggered chaos in the cabin.

“Life is fragile. There was a scary 60 to 90 seconds where we really didn’t know what was going on,” DeWoskin said. “You are 15,000 feet in the air — it’s a scary moment for sure.”

For most passengers on the Delta Airlines inter-city jaunt the experience was no doubt frightening, but Psychology Todayhad a more down-to-earth take than the hyperbolic media coverage.

The Psychology Today article points out that the Delta pilots were simply executing a standard operating procedure in reaction to a possible cabin pressure problem.

“Let’s get it straight. Plunge implies out of control. Fly implies in control,” Psychology Today says. “The plane was flown under complete control from its cruise altitude to a lower altitude where pressurization of the cabin is not needed.”

Of course, it’s easy to say that from the relative safety of an academic journal but up in the air, the atmosphere inside flight 2352 was somewhat less bookish

“One of the flight attendants,” DeWoskin said, “I believe, grabbed the intercom and was just repeating over the intercom stating, ‘Do not panic! Do not panic!’”

As usual, passengers ignored the flight attendant.

“But, obviously, it’s a hectic moment so, the passengers around me, a lot of people, were kind of hyperventilating,” he said.

Share investors face a similar conflict between instinct and expert advice when markets suddenly dive: should you listen to your gut or the flight attendant urging calm over the screams of fellow travellers?

The language of flight (or fright) is commonly used to describe equity investing: stocks soar; indices plunge; markets crash.

However, the analogy is not a perfect one. There is no pilot in charge of share markets (no matter what President Trump may tweet) and investors – unlike DeWoskin et al – can bail at the first stomach-churning sign of turbulence.

But turbulence is a natural part of the share-investing journey; it probably doesn’t make sense to reach for the parachute at the first serious bump. There are techniques that can cushion the impact of market turbulence (see breakout box) – albeit that sometimes there is a return trade-off – but no investors, whether in first-class or cattle-class, can completely avoid volatility.

In simple terms, volatility refers to the scale of price change in an investment over a time period. Given share markets experience constant price movements during opening hours, volatility in this asset class is both more visible and more dramatic than many others (such as property).

Equity markets have also accumulated centuries’ worth of price data that analysts use to both probe historical patterns and plot probable future outcomes. And volatility features prominently in the stock market analysts’ toolkit.

While there are many ways to measure share market volatility, the Chicago Board of Exchange Volatility Index (or VIX) has been the go-to indicator for some time. The VIX – often called the ‘fear gauge’ – actually measures investor expectations of future volatility as expressed in option prices over a certain basket of US shares. Despite the US-centric data, the VIX is seen as a proxy for global share market volatility.

According to a VIX guide published by index provider S&P, historical anaysis would indicate that “a VIX level below 12 to be ‘low’, a level above 20 to be ‘high’ and a level in between to be ‘normal’”.

As at the time of writing, the VIX is just under 15 – putting it squarely in the ‘normal’ zone. After a long period of unnaturally ‘low’ volatility, though, the VIX has spiked higher over the last couple of years: for instance, 2018 was bookended by VIX measures close to 30 or above in February and December. Aside from a couple of smaller volatility bumps in 2015 and 2016, the VIX traded in low-to-neutral ranges since 2012 when markets finally shook off the 2008 global financial crisis (GFC) hangover. (The VIX peaked above 80 at the height of the GFC.)

The expert consensus appears to be that markets are currently flying in unstable air; further volatility is expected with sudden downward dives and sharp upturns likely to be more common.  From a returns perspective, volatility is best understood by looking at some of the peak to trough falls that the US share market  (as measured by the S&P 500 Index) has experienced since 1990.  12 times during this period the index has declined by more than 10%, with the largest fall being approximately 55% in the two years between September 2007 and September 2009.  Today investors who have ridden through this volatility since 1 January 1990 have enjoyed a period where the cumulative rise in the market was over 750% (gross of tax and any fees).

Investors who have exposure to share markets either directly or through managed funds may experience some discomfort; the trick is to focus on the final destination, not the short-term effects of gravity.

Even Dewoskin eventually made it to Fort Lauren after his Delta 2352 scare.

“In hindsight, we turned out all right,” he said

Tips to minimise exposure when investing…

Now, if you don’t want to feel the sting of volatility, there are a few things you can do to minimise your exposure to it. Keeping in mind, the more you avoid it, the further you slide down the risk scale and the more potential returns you might sacrifice.

  1. Diversify your portfolio – It’s good practice to make sure your investment portfolio is fit-for-purpose. In the Managed Funds world, a varied mix of asset types ranging from high-risk to low-risk could help you weather the volatility storm.
  2. Dollar-cost averaging/ Regular investment plan – This is a strategy that involves investing small amounts over time as opposed to one lump sum, meaning you would feel less of the effects of market volatility.
  3. Consider Managed Funds (if you aren’t already) – Managed Funds, by construct, are a way of diversifying your investments. That being said, you’ll no doubt still experience volatility; however, it might seem more palatable.
  4. Be patient and don’t panic – Historical data shows that investors with a longer time in the market naturally see higher returns over the long-period and are less subject to negative volatility effects. As much as you’ll be tempted to sell when things take a dip, sticking it out could be the better option.
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