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The Volatility Wave

by Ross Greenwood

Volatility is the enemy of the patient person; the friend of the opportunistic. Nope, I’m not quoting anybody … I just made it up on the spot. But then I had to check Google to see if anybody else said it first. Nope .. phew … proceed.

Other Google quotes I found are close. “Volatility is an investors’ biggest enemy,” is one.

One of the most respected voices investment theory, Benjamin Graham, author of The Intelligent Investor (though written in 1949, grab it if you can) said: “An investor’s chief problem, and even his worst enemy, is likely to be himself.” (Or herself, I would amend it to today … 1949 was clearly a different time.)

There is a line from the New York Post I like: “There’s a serial killer on the loose – and the deadly enemy is volatility.”

Pretty good hey? You can see these investment types take their volatility very seriously.

Here’s another one, from the legend behind Fidelity’s Magellan Fund, Peter Lynch: “Everyone has the brainpower to make money in stocks. Not everyone has the stomach.” I really like that one.

All of which is to say that you need to strap yourself in and take some Alka Seltzer to settle your nervy stomach. The ride from here, in an era of rising interest rates and energy prices is going to be rocky. Volatility … the ride starts now.

The first thing to know is that if interest rates rise (as they have been on money markets here for the past 12 months) then there is, theoretically, a commensurate fall in all asset prices … bonds, shares, property. That’s because prices must fall to allow the cash generated on any asset to reflect the higher market interest rates.

But remember I used the word “theoretically.” In theory that should happen, but in practice, what often happens is that equity and property markets keep rising as the interest rates rises are stacked on (generally to head off inflation). The reason why markets keep rising (though they become more volatile, there’s that word again) is because inflationary pressures allow businesses to raise their prices to preserve profits; landlords can often raise rents because of demand from workers. Because of the rising profits or rents, the assets underlying those cash flows become more valuable. Markets often keep going.

Indeed, it is not the first interest rate rise (or the promise of it) or even the second, third or fourth that kill off equity and or property markets. It is the last interest rate rise that always does it.

So how many rate rises is that? It’s anybody’s guess … a little like the straws being heaped on the camel’s back. It can bear many straws, perhaps, but one too many and it collapses.

And this is the lot of central bankers like our Reserve Bank. Overseas the straws have started being placed upon their economies’ backs. But though the volatility will increase while these rate rises are added on … there will be a catalyst that will create the biggest corrections of all.

I should note that while our Reserve Bank says Australia is different from the rest of the world, in that inflation has so far not leapt out of its preferred band … one risk is that inflation truly is endemic in our economy … and eventually the RBA will be forced into multiple rate rises more rapidly to catch up with the rest of the world and head off inflationary pressures. But that is a risk, not reality, yet.

And this is where discipline, a strong stomach and patience all become virtues for investors. If you have a group of investments (be it shares, property or whatever you follow) that you have a strong view about the underlaying strength and value … and markets fall to the point that you can buy these “followed” assets at dramatically cheaper prices … it can be life changing.

The things you need to think about are the assets that will keep generating lots of cash, no matter the economic circumstances, and which you know will; exist in 10- and 20-years’ time.

Then patience … wait for the volatility … and act.

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