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Investment Insight: Helping clients ride the volatility wave

With market instability expected to continue, advisers must ensure clients fearing short-term losses do not forfeit long-term gains

“The value of your units may fall as well as rise.” We are all familiar with the risk warnings that have jumped to the front of any document linked
to investment post Mifid II, but have we actually forgotten how healthy these falls can be for the long-term investor?

Volatility is something we have started to fear. It is never an easy task having to justify why a client’s portfolio is worth less today than it was a quarter ago, particularly after such a long period of positive performance. 

As stewards of people’s hard-earned savings, it is crucial advisers take (appropriate) risks to achieve (appropriate) returns for their long-term wealth.

While there are many measures of volatility in the market, the VIX is the most commonly referenced gauge. It is a popular measure of the stockmarket’s expectation of volatility implied by S&P 500 index options. 

The VIX is quoted in percentage points and represents the expected range of movement in the S&P 500 over the subsequent year.

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In 2017, the average level of the VIX was 11.11, with the range showing a very stagnant 9.14 to 16.04, suggesting the market was not exactly expecting fireworks. In 2018, however, the average level has been 17.6, with the range already covering 9.15 to 37.32.

That said, the average level of the VIX since 2010 has been 17.08 – so we have been through an unusually benign period of market moves and are simply moving back to a more normal environment. Fingers crossed it continues.

Going back further teaches us more about the quirks of the VIX. In 2008, it surpassed 80. From 2004 to 2007, market volatility via this measure had been below long-term averages, yet the S&P 500 lost about 56 per cent of its value from October 2007 to March 2009 when the VIX tripled.

What this shows is that the VIX is not a measure of the volatility of the market; it is a measure of the emotional state of the market.

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You can only use the VIX as a hedge against market falls if the level is low and you expect it to rise through fear striking its way through the market, making options more sought after.

If the market does not think there is much chance of a big fall, the cost of insuring against this is going to be very cheap. It is no different to insuring any other asset.

Even before the tailwinds of quantitative easing blew markets to record highs, rising calendar year returns were not usual, but neither were double digit falls at certain points in the year.

Despite the average intra year falls of 15.3 per cent over the past 32 years, the annual returns are positive in 23 of those years. It is no surprise that the year with the biggest falls are usually followed by big rises and vice versa.

The job of advisers, and their ability to measure clients’ appetite to stomach a varying value for their assets, is not an easy one.

In the same way that markets are driven by sentiment, more so now than ever, the emotion of a client who may fear short-term losses will be forfeiting long-term gains for the sake of timing if history is any guide.

Kelly Prior is an investment manager in the multi-manager team at BMO Global Asset Management

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