Sailing through choppy waters

Please note this blog post was published over 12 months ago and so may not include the most up-to-date information, for example where regulation around investing has changed.

Welcome to a special look at a feature produced by our investment team in the latest issue of our quarterly magazine, True Insight.

In this video we’ll take a closer look at recent volatility in global markets, we’ll explain how it is calibrated by the VIX Index and how, through the magic of pound cost averaging, it can be beneficial to those making regular contributions to their investments.

More so than ever, whether it be the Federal Reserve Board, Mark Carney at the Bank of England or the financial media in general, there’s some degree of uncertainty about the course of financial markets.

Does the current slowing of growth herald the “end of the cycle” we’ve been hearing so much about? Or will a pause in, or even a reversal of interest rate hikes provide a further leg to the global economic recovery?

The jury is out.

However, what all commentators appear to agree on is that volatility will increase. And we’ve seen this already. In October last year global equities, in sterling terms, were down 5.2%.

In November they stabilised. December witnessed a fall of 7.5%, much of which was returned during January and February during which they gained 6.8% in a very strong start to the year.

In actual fact, compared to historical norms, markets have not become more volatile. What we’re seeing is perfectly natural. It just feels odd because for so long markets have been buoyed by the tide of easy money from quantitative easing, which has served to “float all boats” and provide the means for markets, in all assets, to rise steadily higher.

That was, in large part, what QE was designed to achieve. However, part and parcel of the economic revival and the return to some sort of normalcy is the reappearance of volatility. As you might expect market practitioners have a way of measuring this, expressing volatility as a number, and increasingly we see references to the VIX index.

The VIX, or to give it its full name, the Chicago Board of Exchange Volatility Index, was first developed in 1992 and, using a complex formula based on the S&P 500 options market, it computes implied volatility on the broad US market.

The VIX index is designed to provide a theoretical expectation of short term volatility quoting the expected, annualised change in the S&P 500 over the next thirty days.

Like much of what happens in the financial markets, what began as an indicator, developed by academics and used by only a few practitioners, soon came to enjoy widespread prominence with the VIX regularly cited in articles describing the nature of global equity markets.

With the current bull market the longest on record, but forecasters undecided on the direction of financial markets and much of the economic picture clouded by geopolitical concerns, turbulence is likely to characterise the foreseeable future and the only certainty may be continued uncertainty.

In what remains a low growth, low inflation, low interest rate world, volatility is likely to persist. It is also likely to be a good way of making money.

Academic research and, more to the point, anyone who has ever tried it, will tell you that it is next to impossible to time markets; to get in at the bottom and sell out at the top.

However, when markets are “trading sideways”, rising and falling but ultimately not really moving up or down, they lend themselves to regular investment.

Through the alchemy of pound cost averaging, regular savers investing a specified amount over a period of time stand a better chance of outperforming the market compared to an initial lump sum investment. As the chart shows, in volatile markets, regular savers investing the same amount each time will buy more shares or units of an investment when prices are lower and fewer when prices are higher. The upshot of this is that their average cost is likely to be lower than the average price of the investment over the period in question.

So, making regular commitments will bear fruit and while investing in uncertain markets is unnerving, the rewards of outperforming in volatile conditions are particularly sweet.

Subscribe to our youtube channel for more investment insights, and join us next week when we’ll be taking a look at emotional habits of investing. Thanks for watching.

With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest. Past performance is not a guide to future performance. Tax rules can change at any time. This blog is not personal financial advice.

Global Markets