There is no period in the last three decades where the “feel” of the market diverged so far from the actual performance. The investment implications of this misleading impression are important. There is strong evidence to show human decisions are affected by emotion, despite the classical economic theory of a rational robot consumer “maximising personal utility”.
Rising interest rates. Looming trade wars. Lending bubbles, overheated markets, and forecasts of increased volatility. There’s a lot for investors to fret about. This worry means in many investors’ minds the market action is hectic, verging on frantic. So charts must be showing these increased market gyrations, right?
Um, no. Here’s the big picture of the Australia 200 index:
This chart shows market movement since the year 2000. Each candle represents one month of trading. The mountain on the left of the chart is the great bull run that peaked in November 2007, culminating in the GFC.
While the market may “feel” highly volatile, this chart shows that last year was one of the least volatile this century. Individual stocks swung wildly, but the overall market impact was muted. For much of 2017 the index was trapped in a narrower range between 5,650 and 6,000. Despite bubbling higher at the turn of the year the index is now back in this range.
Personally I can’t recall a period in the last three decades where the “feel” of the market diverged so far from the actual performance. The investment implications of this misleading impression are important. There is strong evidence to show human decisions are affected by emotion, despite the classical economic theory of a rational robot consumer “maximising personal utility”.
Perhaps the most apparent risk is that an emotional understanding of the market could lead investors into more fear than is realistic. Fear can cripple action, and it can cripple returns. A less well understood risk in investment is underperformance. Wealth is relative, and when we increase our wealth at rates below others we become relatively poorer.
If worry drives investment decisions it affects every aspect of the investment process, from asset allocation to holding times. Overly worried investors are likely too heavily weighted to cash, to bonds, and to other defensive assets, yet the sideways share market movement of 2017 had a positive bias. An index portfolio recorded a capital gain of around 6% and a dividend yield of around 4.5%. Throw in some franking and index share investors received around 12% - significantly outperforming the 1-4% returns of cash deposits.
A 12% annual return would see a portfolio double in value in about six years. At 4% it takes around eighteen years.
Putting aside an impression of the market to study its real trajectory, and investing accordingly, can lead to superior long term returns. None of us can predict the future with total accuracy, but an understanding of current conditions and how they may evolve can drive a more robust and ultimately more successful investment process.
Strategic implications of current market conditions
First of all market volatility is not as high as the headlines would have us believe. This is more than an academic observation. Lower volatilities mean lower option prices, all else being equal. Investors who have taken the time to acquire knowledge and skills around the investment uses of options are in a strong position. One-sided risk profiles (unlimited profit, limited loss) that are created with options are powerful investment tools in current conditions.
Secondly, there are two lines in the sand that may put investors on alert that market behaviour is changing. They’re marked on the chart at 5,650 and 6,000. Any moves outside these range boundaries change the outlook. The move above 6,000 late last year ultimately proved a false break, but some chartists now look to 6,150 as the upside boundary.
A defined trading range offers an opportunity where active investors are dominating returns. Buying that share when the market is nearer the low end of the range is a lower risk approach. Similarly, banking an extraordinary gain in a top performing stock when the index is near the top of the range increases the likelihood of maximising returns.
This article first appeared in the Australian Financial Review.