What professional fund managers do in the face of volatility
By ATB Investment Management Inc. 31 March 2020 6 min read
Let’s start with the basics about volatility and risk
Stock market volatility and risk are often used interchangeably however, they are not the same thing and understanding the difference between the two is important.
Volatility measures fluctuations in stock prices. The smaller or larger the volatility, the smaller or larger the fluctuation in prices. Volatility is commonly expressed as standard deviation, which is a statistical term that measures dispersion around an average.
We would define risk as the permanent loss of capital, which is what most people actually fear. Risk is also the inability for someone to live out their financial goals and dreams due to the impairment of their capital.
During periods of sustained market volatility, financial professionals often provide the advice to “stay invested” which may come across as being disingenuous. However, it is truly the best advice. Capital can become impaired if one was to sell at the bottom of the market and it can be hard to make that money back, especially if you were a long-term investor before selling out.
When we think of periods of volatility, we often hear the words; corrections, bear markets and recessions.
While we can experience volatility through the price movements of stocks and bonds that trade on major indices throughout a day, in the data above we can also see that corrections, bear markets and recessions happen more often than we realize.
Let’s review some of the ways we can protect our assets in times of duress
Diversification and asset mix
The volatility we experience in our portfolio is directly tied to the asset mix and level of diversification we have in our portfolio.
On its simplest level, asset mix is the split between bonds and equities within a portfolio.
Diversification refers to the collection of bonds and equities that make up your portfolio. In its simplest form, your level of diversification is related to the number of individual positions within your portfolio. Holding one single company would mean your portfolio has less diversification and higher volatility. This is compared to holding several companies that operate in different sectors and geographic regions, which is a higher level of diversification and lower volatility as the risk is spread amongst the various companies held.
If you are working with an advisor, your asset mix will be tied to your individual risk tolerance. Risk tolerance is just a fancy way of saying how much day-to-day volatility you are comfortable with. This will vary from person to person as some are comfortable with high volatility (more equities in the portfolio) in exchange for higher long-term returns, and others prefer less volatility (more bonds in the portfolio) in exchange for lower long-term returns.
Investing is not a one-size-fits all, risk tolerance should take into account an investor’s willingness and capacity to take on risk, their time horizon and various other metrics to ensure an appropriate portfolio that they can continue holding throughout market peaks and troughs.
Let's take a look at how various investments have performed so far this year, from single stock exposure to the well-diversified CompassTM Portfolios with various asset mixes.
You can see from the data above that the volatility incurred is much greater if we look at single stock exposure like Suncor compared to a basket of Canadian large-cap equities represented by the S&P/TSX index. If we further diversify and add bonds to our portfolio, we can see that volatility is even further reduced as represented by the Compass Balanced series A portfolio (45% bonds and 55% equities) and Compass Conservative series A portfolio (80% fixed income and 20% equities.
One of the outcomes to the extreme volatility we are now experiencing is that it can help set portfolios up for long term success.
Behind the scenes in the Compass Portfolios, the fund company (ATB Investment Management Inc.) is keeping a keen eye on the portfolios target asset mix and rebalancing when appropriate.
During periods of volatility, that typically means selling the higher performing bonds and adding to the lower performing equities. We also have active sub-advisors who are rebalancing the individual mandates that they manage for the Compass Portfolios.
This means our equity sub-advisors are looking to trim the positions of companies that have performed well and add to equities that now have cheaper valuations. These could be companies that they have been following for several years, or maybe companies they already own. They would all be companies with strong balance sheets with sustainable cash-flows and due to the volatility are trading at prices that represent good buying opportunities.
This disciplined process of buying low and selling high is the same philosophy that we try to instill in our clients. This activity sets the Compass Portfolios up for long term success, in the form of compounding returns.
Once the volatility subsides, which we know it eventually will, the process of price discovery will take over and bond and equity prices will go back to a more normal trading band. In buying quality, well-run companies at low prices today, we can provide an incredible starting point and platform for future growth within the Compass Portfolios.
You can see it below in the Compass Balanced series A total return chart. When investors were in the midst of the intense volatility of 2008, the returns we experienced over the next 12 years would have been laughable. However, from January 1, 2008 to March 27, 2020 the portfolio had a cumulative return of 77.4% or a net return of 4.79% yearly.1
Adding some perspective to volatility
During times of stress, when our emotions take over, it can be helpful to take a deep breath and focus on the things we can control vs. the things outside of our control. So let's think about our current landscape of volatility and a few of the basic things within our control and outside of our control.
We can’t control
- Unfortunately we are unable to control the frequency of news that is being produced by the media today or tomorrow.
- We are unable to time when the volatility will end, or when it will begin again in the future.
- We are unable to control the daily price volatility in the markets.
- We cannot control the amount of savings we currently have to date.
We can control
- We can control our responses to the news in the media.
- We can control how often we read the news or watch financial media TV.
- We can control our asset mix, which as shown in the charts above, can help to predict the future growth of our portfolio along with the volatility we experience.
- We can control the time we spend connecting with friends and family and re-focusing on the reasons behind why we are invested.
- We can adjust our rate of savings going forward.
Professionally managed funds are for times like this
It is hard for us to say when this market, economic and social turmoil will end. While this unknown can lead to some anxious feelings, it can help to focus on the things that we do know.
We do know that stock markets will eventually recover. We say this having 95 years of modern stock market data to review. History has shown us that following steep declines in the stock markets we experience significant market growth. This is key information that fund managers use to recover during times of volatility.
We also know that once this period of social distancing is over, people will want to get out of their houses. They will go back to eating in restaurants, drinking on patios, and resuming their normal spending habits. Companies will also be looking for innovative ways to make up for revenue that was lost.
Recovery won’t happen overnight and we’ll all be faced with a new world when we can leave our houses again. For right now, focus on what you can control and hold your family and loved ones close.
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Bloomberg, ATB Investment Management Inc.
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