Yo-yo markets that are up one day, down the next, continually promising gain or loss, are among the hardest to endure. To be able to stay committed to investing in volatile markets, it helps to step back and ask yourself why you are invested and for that matter, what exactly investing should mean.
Investing is very different than trading. Investing typically takes one of two forms. (1) We loan money to a business or entity with the expectation that the money will be repaid with a negotiated return or interest rate. (2) We purchase an interest in a business or property with the expectation that management will increase the value of the asset and generate income, providing a return on our investment. In both cases we are making a value judgment as to the likelihood of receiving a future return on our investment.
Trading seeks to take advantage of short-term inefficiencies in the market where return is based on changes in the purchase price of the security, whether bond or equity.
The volatility of prices in the market for debt or equity typically does not change whether or not our decision in purchasing an investment was a good one. A bond purchased from a company with the financial wherewithal to meet its obligations is not a better or worse investment if its price fluctuates in response to market volatility. A company with sound financials and good growth prospects, whose stock was purchased at a good value does not become a bad investment because the market enters a downtrend. The reason is all in the word – future. If you believe the company continues to offer future potential, that the economy will grow over time, that demand will continue for the products and services the company offers, then the investment remains a valid one.
This is why buy and hold is a viable investment approach for younger investors with time to weather market volatility. One invests in good companies, whether through stocks or bonds, monitors the companies to make certain their financial and growth prospects remain good, and sells when the reasons for initially investing no longer hold true.
The problem with a buy-and-hold approach occurs if the investor needs to sell his/her investments in the near future to meet anticipated financial needs, whether financing an education, starting a business, retiring, or taking advantage of an opportunity that may not come along in another year or so. The luxury of time to wait for a market recovery disappears and it becomes more important to protect the present value of the portfolio.
This is where active management plays an important role. Active management says we don’t know how low the low might be. But we do know that our investor has limited ability to make up losses. We chose to limit the downside of the portfolio by moving out of the market or into lower risk positions when downside volatility increases. When the market appears to have established an uptrend, assets are moved back into desirable investments to take advantage of opportunities to build wealth through appreciation.
In yo-yo markets, active management can suffer whipsaws, short-term movements in the market that result in selling a position only to have to buy back at a higher cost. But given our inability to see the future and the need to limit losses, this is typically considered the lesser risk.
Approaching active management purely as a trading strategy is a very different investment style. The goal in this case is not to invest in good companies or bond issuers based on their future performance, but to take advantage of inefficiencies and irrational market moves to achieve profits. Maintaining a long-term commitment to a trading strategy requires knowing how the strategy works in different markets and analyzing the current market to ensure that the approach is working as it has in the past. If it isn’t working, the investor needs to move out of the market to rethink or wait until the right environment for the success of the model is in place.
It’s hardest to stay with your investing approach over the long term when you haven’t really thought about why you have selected the investments you hold. Or, if you are working with an investment advisor, why your advisor has selected specific investments and what the criteria are for holding or selling. When you understand why - given it makes sense to you - it’s much easier to invest through volatile markets and still sleep at night. Which is why we encourage clients to contact us with their questions. We want to make certain they understand the reasons behind our investment approach. Investing succeeds best as a long-term approach to the market.