Thoughts on the Market – Volatility and Market Timing

The Singapore market was a sea of red on Wednesday. The STI Index dropped 3% within a day, its biggest fall since 2011. It recovered slightly over the next two days but still ended the week down close to a hundred points. What is the market poised to do when it opens tomorrow?

Regular readers of BigFatPurse will know that we never comment on market direction. Pundits and gurus who claim that they can predict what the market will do in the future are either very smart or very foolish. We are neither.

Truth is, the financial market is way way too complex for anyone to understand fully all the factors that may influence its movements. Known unknowns are aplenty. For example, we know that China is going to devalue its currency but to what extent will it actually affect the STI is anyone’s guess.

On top of that, unknown unknowns are always lurking around the corner. All hell breaks lose when a totally unexpected event happens. What happens if an epidemic hits? A war breaks out? Another country chooses to default on its debts?

So, if you are here looking for direction after last week’s bloodbath, I am sorry to disappoint you. I cannot tell you to sell or hold or to buy more. Your guess is as good as mine.

However, the recent market movements gives us a good reason to re-examine some fundamental concepts regarding volatility and the premises of value investing.

Two ways to make money

There are two ways an investor can make money from the markets. He or she can either Pick stocks or Time the Market.

Stock picking is also often known as value investing. Understand the fundamentals of companies, discover undervalued stocks and buy them before the market recognises their true value. Over time, price will converge with value and profits will be realised. Easy enough.

Timing the market, as the name suggests, is buying when the market is deemed low and selling when it is high. In its purest form, there is no need to look at the fundamentals of the stock or ETF or commodity or currency that you are buying. An investor just needs to buy whatever that has the highest potential for gains.

There are pros and cons to each method. Value investing is slow and boring. To succeed, patience is of utmost importance. Yet, patience is something many of us lack. Value investing does not require one to time the market because by an investor is already buying stocks cheaply.

Timing the market is exciting. Being in the thick of market action causes that adrenaline rush and gives us hope of making a fast buck. Unfortunately timing the market is something professionals, not to mention retail investors fail to get right many times.

It is up to the individual investor which approach he or she wants to adopt. There is no right or wrong way forward. Both schools have their success stories, with Warren Buffett being in the Value Investing camp and George Soros being from the market timing (Global Macro Investing) camp.

Can we do both together?

There is a contradiction to both methods though. Value investing requires an investor to remain vested through good times and bad. Time in the market is more important than timing the market, says the value investor.

Now the problem arises when retail investors try to do both – pick stocks and time the market at the same time.

Imagine during peacetime, when the economy is doing well and the stock market is humming along fine, an investor would seek out good stocks to buy. He comes across a stock that is trading at $1 but has assets worth $2 per share. It is a steal. He cannot find another one that is as good, so he loads up and fills his entire portfolio with the stock.

The next week or month comes along. The market undergoes a correction, not unlike what we saw in the market last week. The entire market was murdered. This fine stock was not spared and loses 10% of its value. It now trades at 90 cents, and from the looks of things, has the potential to drop further.

The fundamentals of the stock remain unchanged. It is still undervalued. In fact, it has become even more undervalued. Unfortunately this is also the time where most investors can no longer take the pain and sell out. They promise themselves they would buy it back when it hits rock bottom. The day may or may never come.

Good stocks do fall in price

One of the biggest misconceptions investors have about investing in the stock market is that as long as they invest in good stocks, they will never lose money. That is furthest from the truth.

In a stock market correction/crash, every counter will be affected. Bad stocks become cheap, good stocks become cheaper. During the Global Financial Crisis in 2008/2009, even if you are holding the biggest and best companies in Singapore, you would have still lost more than half your money.

The Monster called Volatility

Which brings me to the next point – an investor who chooses to invest in stocks MUST be able to withstand volatility.

Blue chip stocks are more bigger, better and more established companies. They are less likely to go out of business. It does not mean that their shares are any less volatile.  It certainly does not mean that their shares will never drop in price. Do not for a moment think you will always be looking at gains just because you are buying blue chip stocks.

Retail investors often confuse volatility with risk. Volatility is a measure of variation. It is a measure of how much something moves. If a stock moves a lot, it is said to be volatile.

Risk, on the other hand, can be taken to be the possibility of losing money. At first glance it is very similar to volatility but it is a totally different concept altogether.

Here is an example to differentiate the two. Suppose there is an investment that allows you to buy gold and receive fixed dividends every month. You end up investing a sum of money and receiving 2% a month. The returns are fixed and the value of the investment does not change. It is low in volatility.

Now we also know that anything that promises outlandish returns might be a scam. Gold is a negative yielding asset. You need to pay to store it, and not take money from it – that in itself should set off alarm bells . The is a good possibility that you might lose your entire sum of money. Despite the volatility being low, the risk is extremely high!

We have written about risk and volatility before here.

A way of life

Volatility is a way of life for all stock market investors. Last Wednesday’s 100 point drop in the STI is not the first, and it will not be the last.

There will be many more of these days in the market in the future. If an investor has lost sleep last week, he or she will do well to re-look the portfolio. Based on his or her risk profile and tolerance for volatility, there are other lower volatility instruments to invest in.

image – globaltrendtraders