Stick, Twist Or Fold? In The Face Of Volatility

Don't get spooked by volatility caused by headline events and look at the longer term

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Reviewed by: Stacey Ash
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Edited by: Stacey Ash

2013 set a marker for major equity markets, not only in terms of some stellar performance numbers, but it also marked the lowest year for volatility since 2007 – something which might have escaped the casual investor's eye.

This was despite uneasy speculation over the end of quantitative easing and the temporary US Government shutdown. The fact that this marker hasn't really featured in the headlines is simply a reflection of human nature – people only worry about volatility in downward markets and they become complacent when markets trend up steadily.

However, 2014 has certainly reminded investors that volatility is not a one way street. Fears around QE tapering came to the fore in January with the appointment of Federal Reserve chairman Janet Yellen, and volatility was seen most vividly in reaction to Russia's "invasion" of Ukraine this month. The resulting pick up in volatility has prodded investors out of their complacency to ask themselves how, or whether, they should act.

For the fundamental investor, this involves weighing up the economic impact of, say, any sanctions on economic growth on corporate earnings in the US or higher energy costs coming out of Russia. However, investors using a purely computerised trend-based system have a simpler choice, provided their system excludes the possibility of human intervention caused by fear bias. With all the recent commotion, are the trends intact or have they changed?

A trend-based system works over the long term

Firstly, one must decide on the time horizon used to measure a trend. The high frequency trading systems employed by the investment banks may measure trends over seconds, minutes or hours, but these systems cannot realistically be replicated by the majority. Most investors have a longer term horizon than intraday, and the costs involved of switching investments can be punitive.

I would argue the optimal timeframe for a computerised trend-based system is six months. Even better that the system takes volatility into account. This prevents investors from being whipsawed by events such as those we've seen this year. In behavioural finance terms, this helps avoid "recency" bias or "loss aversion" bias.

Our top ten index-based investments in February haven't been shaken out from January due to the recent pick up in volatility:

 

28/02/2014
Rank
Asset NameRank on
31/01/2014
1UK Equities (Mid Cap)4
2European Equities (Small Cap)2
3US Equities (Technology)1
4European Equities (Mid Cap)9
5UK Equities (Small Cap)6
6European Property13
7US Equities (Mid Cap)11
8European Equities (Dividend)3
9UK Equities (Large Cap)12
10UK Corporate Bonds (Over 15 Years)5

 

Upwards trends despite volatility

 

Look at a chart below of the top index investment, UK mid cap equities. We can see recent volatility, but the trend over the last few months has still been upwards and positive, as shown by the solid line and calculated mathematically.

 

Source: Sharescope

"The trend is your friend until it reaches the bend"

We prefer to use the measure of probability to decide if a trend is positive, rather than use subjective analysis. We accept it will not always be correct, but there's more likelihood we will get it right than wrong.

The UK mid cap index above has only been held by iFunds since January, but the longest held investment (below) in our top ten has been held since August 2013, despite some of the wobbles along the way.

 

Source: Sharescope

Beware corporate bonds

Interestingly, it is a perceived lower risk asset, but corporate bonds look most vulnerable to its trend line turning negative. Bond prices will need to remain positive in order to counteract the effect of the removal of the strong price action [quantitative easing] seen during October and November of last year, otherwise the main trend line will start to flatten out.

 

Source: Sharescope

Stick, twist or fold?

None of us know the outcome yet. But at least from a fundamental point of view, regarding Ukraine, what the trend-based investors know is what the historic price data is telling them - and that is "stick".

It is only when we can see the "bend" in the trend over the longer term that we need to act. This method can't allow the investor to buy at the bottom or sell at the top, because the system doesn't know until the trend changes, and that is based on historical information.

However, a long term trend can help us from being spooked out of markets due to headline events that might not have any influence on economic fundamentals.

Stacey Ash is director and investment manager at iFunds Asset Management