Trading Themes

Surfing the volatility

A market without volatility would be unnatural, like an ocean without waves. For some investors, market-moving waves can be exciting, providing trading opportunities for mispriced securities. For other investors, the waves might feel violent, especially if they are on the wrong side of the trade.

Game of volatility

In surfing lingo, there are two basic types of ocean swells — wind swells, which are generated by local winds, and ground swells, which are generated by winds blowing over longer distances. From an investor’s perspective, wind swells are similar to the market’s short-term price swings in that they are short, fickle, and difficult to ride. Conversely, ground swells are similar to the market’s long-term investment trends in that they are long and fairly predictable and require little effort to ride.

The average surfer prefers riding predictable ground swells and does not waste energy chasing fickle wind swells. However, the average investor does the opposite; overlooking predictable long-term investing trends while fruitlessly attempting to ride flighty short-term price swings.

Markets tend to rebound following pullbacks. This means that investors who jump ship after a big wave may have broken the cardinal rule of investing by “selling low.” The last thing an investor should do is to be on the bench when the market starts to trend. Frequent pullbacks in the market can be unsettling, but are normal and necessary as smart money builds their positions. That is why it is important for investors to ride the wave of volatility through its full cycle.

Portfolio rebalancing

A surfer has to periodically rebalance his position on a wave in order to keep riding it. Good surfers move forward more efficiently than novice surfers by knowing when and how to rebalance their surfboards back toward a wave’s power source (or “pocket”). From an investor’s perspective, broad asset classes like stocks, commodities and currencies are similar to breaking waves in that their performance also ebbs and flows over time. While equities and commodities tend to perform better with economic growth and moderate levels of inflation, fixed income and safe haven currencies are important to portfolios when growth falters.

Although it seems logical that investors would periodically rebalance their portfolios’ asset mix, the reality is that they generally don’t. This irrational behaviour is likely a result of the fact that portfolio rebalancing requires plan participants to sell recent winners and buy recent losers — a counterintuitive endeavour for most investors.

Ideal asset allocation strategies vary depending on factors like taxes and transaction costs, but there are a few simple rules of thumb investors can use when developing game plans. A rebalancing strategy based on reasonable monitoring frequencies (such as annual or semi-annual) and reasonable allocation thresholds (variations of 5% or so) is likely to provide sufficient risk control for most portfolios with broadly diversified assets. Similar to surfers, investors will ride the market’s waves of fear and greed more efficiently if they develop game plans to systematically rebalance their asset mix back toward the optimal weighting.

Rule of diversification

Different ocean conditions call for different surfboards. Avid surfers know they are required to own a diverse collection of surfboards, allowing them to ride a variety of waves. From an investor’s perspective, market conditions are also constantly changing and, as in surfing, no single asset works well in every market condition. Thus, diversification is as imperative when investing as it is when surfing.

However, studies have shown that most individual investors struggle with this concept. A large portion of individual investors hold under-diversified investment portfolios, which ends up being a costly mistake.

Perhaps because investing is more of a mind game than a physical one — investors seem to have trouble deciphering whether or not they are wiping out. For instance, a paper titled “Why Inexperienced Investors Do Not Learn: They Do Not Know Their Past Performance” notes that fewer than 5% of the investors surveyed believed they experienced negative returns while more than 25% of them actually did. It is obvious that individual investors would benefit from more-accurate feedback regarding the performance of their investments and a higher level of portfolio diversification.

 

Just like ocean swells, volatility bring risks and opportunities. A balanced and uncorrelated asset allocation with periodic adjustment in a shape of an all-weather portfolio can help achieve investor’s financial goal. Focusing on the long-term investment objective rather than the short-term market gyrations should also give investors the confidence to ride the waves of volatility.

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