Every investor in the share market must deal with volatility, the term for ups and downs in the prices of shares. The bigger the variations over a particular period, the more volatile the market is considered to be.
There is no escaping volatility, because shares are up for sale all day, every weekday.
There are two kinds of volatility, that of the overall market and that of a single stock – and these will be quite different figures.
In both cases, investors need to be able to sleep at night if their capital drops by 25% in a stock market crash, or a bad market reaction to one of their portfolio companies. History tells you that, since 1950, according to research firm Andex Charts, the Australian share market, as measured by the S&P/ASX 200 Accumulation Index (which counts capital growth plus dividends) and its predecessor indices, has delivered a return of 11.7% a year, with the contribution from capital gains and dividends shared roughly equally. Of course, there is survivorship bias in that figure – the companies that survive generate most of the returns, and it certainly will not represent the return of every share market investor in their own portfolios, but that is what “the market” has generated.
But for that nominal return, there is the ever-present and unavoidable risk of the share market index falling by 10% or even 20% – which it does, frequently. The S&P/ASX 200 index has had seven falls of 10% or more in the past ten years; most recently, this year. And no investor will forget in a hurry the spectacular four-week crash that stripped 33% from the S&P/ASX 200 in February-March 2020.
Such an event takes virtually every stock with it and erases months, even years, of patient capital appreciation.
It can be worse in individual stocks. Even if the general market is rising, a company that brings out bad news – especially if the market was not expecting that news – can have its very own crash, with falls of up to 40% possible.
Market turmoil this year has pushed volatility levels higher. The measure of volatility in the US market, the Chicago Board Options Exchange’s CBOE Volatility Index, or “VIX,” is up 55% in 2022; its ASX counterpart, the S&P/ASX VIX, is up 46%. But both have come down sharply from their levels in early October; and neither is anywhere near the kind of historic highs reached in extremes like the GFC of 2007-08 and the “COVID Crash” February-March 2020. Right now, both the US and Australian VIX indices are about 62% below their “COVID Crash” peaks.
Investors should always try to protect their portfolios by being diversified; but even that does not help when the whole market is down. Broad market exposure is a sound long-term strategy, but an exchange-traded fund (ETF) that tracks the S&P/ASX 200 index is going to be down close to 10% for the year.
Another theory of safety in the market is to focus on the “blue-chip” stocks, those with the best track record over long periods, but again, a broad market downturn has this group trading in the red for 2022. Even a stock like CSL, which I think is virtually the bluest of blue- chips in the S&P/ASX 200 – it is one of the world’s leading biotechnology companies and the name behind the CSL Behring, CSL Vifor, and Seqirus businesses – is showing a 6.2% loss for 2022, right now.
In a similar vein, there would be many investors who put their faith in defensive blue chips that should continue to experience solid customer demand during a downturn – think stocks like Woolworths, Coles and Telstra – but even that trio is down 15%, 9.1% and 8.8% for the year to date.
Another approach is to try to maximise the dividend income aspect of your shareholding, because dividends from the top dividend-paying stocks are not as volatile as share prices. There are a range of ETFS that are designed to maximise dividend income, such as BetaShares’ Australian Top 20 Equity Yield Maximiser Fund exchange-traded managed fund (ASX code: YMAX), Vanguard’s High Yield Australian Shares ETF (VHY), VanEck’s Morningstar Australian Moat Income ETF (DVDY) and Plato Income Maximiser Fund Ltd (PL8) and BetaShares Australian Dividend Harvester exchange-traded managed fund (HVST). The obvious issue here is that the share prices of most of these funds’ constituent companies, even though they are the top dividend payers, are likely to be down for the year to date – and thus, so could the prices of the ETFs be – although PL8 is doing a great job for investors, showing a 1.7% rise so far in 2022, and VHY is only down 3.1%.
There are also ETFs built to isolate the stocks with the lowest volatility, to offer a low-volatility exposure to shares. For example, the iShares Edge MSCI Australia Minimum Volatility ETF (MVOL) follows the MSCI Australia IMI Select Minimum Volatility (AUD) Index, theoretically isolating the Australian shares with the lowest volatility in one ETF. However, MVOL is showing a worse fall than the market year-to-date, down 13.9%.
MVOL has counterparts on the ASX that follow the same approach with global shares.
Vanguard Global Minimum Volatility Active ETF (VMIN) seeks to provide long-term capital appreciation with volatility lower than the FTSE Global All Cap Index (and is hedged into A$): VMIN is down 10.6% for the year. The Global X S&P 500 High Yield Low Volatility ETF (ZYUS) is designed to give investors a return that tracks the performance of the S&P 500 Low Volatility High Dividend Index: ZYUS’ combination of high dividend yield and low volatility has been a winner this year, with the ETF showing a 7.4% rise so far in 2022.
Another alternative is to use alternative asset classes that show an inverse correlation with the share market, meaning they usually go up in price if shares go down, and can protect capital in a portfolio. Gold is often (not always) in this category: the Global X Physical Gold ETF (GOLD), which is accessible at any time on the share market, for any amount of investment, is showing its mettle in this task this year, trading on a 3% gain so far in 2022, against the market’s 9.6% fall.
Investors concerned about volatility to the point of wanting to take protective action have several options available to them. They can hedge their portfolio to some extent, by holding an asset that can rise in value if the share market falls. For example, an investor could use contracts for difference (CFDs) to take a short position on the S&P/ASX 200 index, or more accurately, an index that mirrors this index, offered by the CFD provider (which might be called the Australia 200 index.) Index options traded on the ASX can be used for the same purpose. The problem with these exposures is that, like any insurance, they cost money to implement. Also, it is difficult to set up a situation where you are perfectly hedged; and it is neither easy nor cheap to remain so: an investor would have to constantly update the hedged position, to reflect moves in the underlying index. There are even more sophisticated strategies that use more technical approaches, but again, these are not cheap – and the insurance could end up costing you more than the loss against which you are trying to protect.
Share traders, of course, can protect against volatility by using stop-loss orders and take-profit orders, and traders actually like volatility, because of the opportunities for profit it can bring. Longer-term investors can use the same approach, if they research and know stocks well, and can turn an over-sold situation to their advantage; or outsource that task to a professional active fund manager that takes the same approach. But whether investors try to protect against it, or look to profit from it or simply just accept it as a fact of life – every share market investor has to deal with volatility in some way.
The last approach to volatility I will mention is probably the most likely to succeed, over the long term – dollar-cost averaging. This is the process of investing the same amount of money into shares or funds every month (or quarter), by which method the investor will buy more shares when prices are down (and conversely, less when prices are higher), which reduces the investor’s average cost per share in a holding accumulated over time. You are not trying to “time” the best times to invest: the strategy is automatically doing that at time when the market is down, and over time, working to maximise your gains and minimise your losses. In that way, over time, you are getting that great share market bugbear, volatility, to work for you.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
