What to do in the face of volatile share prices

More often than not, the best advice for advisors and clients when dealing with volatile markets is to do nothing. But when a stock drops, the initial reaction is to do something — it’s built-in investor psychology. Unfortunately, our brains provide us with a short-term payoff at the expense of longer-term financial success. Closure, satisfaction, a false sense of control or a greater sense of importance — they all betray our better intentions.

On average, making too many short-term, reactive decisions leads to investment underperformance — it’s called chasing the markets. However, it’s also referred to by more technical terms such as sector or style rotation, or momentum investing. The false belief that anyone or any system is capable of timing the markets is the unwitting demise of many an investor. Over the short term, the market is far too complex to predict, and also exhibits its own seeming personality flaws that can’t be quantified.

This is not to say you should ignore the market. Advisors must be in tune to those situations when an investment thesis breaks or, likewise, when a stock shoots far past fundamental longer-term value. However, these tend to represent the vast minority of volatile share price movements.

The big stumbling block for advisors to do nothing is, of course, that nagging pull of investor psychology. The best approach to manage it effectively is with a process that enforces patience.

For example, advisors can institute a blackout period before any investment changes can be made following a share price drop. Usually, the results of acting quickly are small when viewed in the grander scheme, which should always involve a diversified portfolio and a time frame of years (not days). By waiting, you allow the market to correct to reflect fundamentals, not misjudged sentiment.

Granted, this requires a sound investment thesis to start. As long as fundamentals hold true and the long-term growth plan remains in place for a company, the market will reward patience and sound analysis.

The bigger challenge is selling clients on the idea of doing nothing. Encouraging patience while taking short-term and sometimes repeated hits is no easy task. If doing nothing is so often the key, clients might question why so much sell-side investment research is focused on the short term. Why do 12-month price targets and ratings seem to blow around with the wind?

The reality is that most sell-side research is meant to be consumed quickly and daily by institutional fund managers who continue to believe they are the ones who will outperform the market. Studies show, however, that 97% of active fund managers underperform the index over longer periods, and those that do outperform cannot match the feat in subsequent years.

A big reason for the underperformance is fees, which is a good reason to focus on your own model portfolios for clients, whether composed of individual stocks or low-cost ETFs.

Another good reason for patience is that a greater amount of short-term reactionary trading is driven not by humans but increasingly by the use of automated strategies, which you can’t out-manoeuvre. But you can definitely out-strategize them over the longer term.

Perhaps the biggest advantage to focusing portfolios on the longer term is the amount of time you can reinvest in helping your clients. By instituting a low-turnover, proactive, diversified model portfolio, you can achieve not only higher returns but also room for other value-added services, such as estate planning and insurance. These activities (not stock trading) are what will compound significant value in your practice over decades.

It’s important to remember that advisors are well down the line in terms of being informed of market developments, and most sell-side research is not meant for them. The easiest way to parse most research is to question whether it will be relevant in six months. By focusing on only changes that affect the longer term, advisors can avoid making reactionary decisions that, over time, have proven to underperform.

Advisors can’t beat the market today, but, over years, they can outperform the large portion of investors who continue to overreact due to investor psychology and an industry that too often emphasizes short-term thinking and fees.

Mark Rosen

Investments

Mark Rosen, CFA, MBA, CFE, heads ARC Research, providing independent equity research to investment advisors across Canada.