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Root Causes of Volatility and Preparing for the Unexpected

By Mike Schnitzel April 20, 2020

This is Part 1 of Financial Advisor IQ’s five-part special report on how financial advisors can help their clients through periods of volatility.

Volatility doesn’t just happen. It can be a response to a major world event or a sign of investor anxiety. We begin Financial Advisor IQ’s special report on volatility by examining its underlying causes and guiding advisors how to prepare for when the unexpected happens.

John Streur, CEO of Calvert Research and Management, says market volatility is caused by two factors.

“The volatility itself isn’t the problem, it’s an investor’s time frame combined with volatility.”
John Streur
Calvert Research and Management
The first is increased uncertainty, which can come in the form of unexpected corporate earnings results or macroeconomic data such as the nonfarm payrolls report, Streur says. The second is “exogenous shock” that could be triggered by something like the September 11 terrorist attacks or the coronavirus pandemic, which has upended the lives of the global population and has led to fears of a recession.

Francis Gannon, managing director and co-chief investment officer at Royce Investment Partners, agrees that uncertainty is a key trigger of volatility.

“Uncertainty has always been a primary cause of volatility in the market,” Gannon says. Various sectors and types of businesses react differently to volatility, he notes.

Volatility is hard to predict precisely because it is unexpected, but it can be dealt with more efficiently when advisors help investors prepare a response, Calvert’s Streur says.

“If the focus is short-term, volatility will be a big problem. But if our focus is a longer term, these bouts of volatility are part of the process and won’t necessarily derail investment plans,” he says. “The volatility itself isn’t the problem, it’s an investor’s time frame combined with volatility.”

Derivatives can be used as a hedge against volatility, but they are expensive and aren’t always necessary, Streur says.

It’s important for advisors to plan for volatility with their clients and to gauge their risk tolerance correctly, said Steve Lee, chief investment officer and managing principal at JFS Wealth Advisors. Once advisors and their clients agree on a plan, they need to stick to it and also have the ability to pivot if needed, to withdraw any needed funds for an emergency, or to use volatility as an opportunity to rebalance asset allocation within a portfolio.

Volatility comes in phases, and there is generally a pullback after the first phase, Streur says. He cites the market impact of Donald Trump’s surprise victory in the 2016 presidential election as an example.

“When Trump won the presidency, the markets dropped like a rock — about 1,000 points,” he says. “Then people stepped back and said, ‘He might be great for business,’ and it went back up. When we have shocks like this, there’s always an initial pullback.”

Streur says longer-term investors can be coached by advisors to use volatility to their advantage.

“One of the things we’ve seen out of this recent volatility was a rebalancing where investors were allocating more to equity and less to bonds,” he says. “A disciplined asset allocation approach, with the proper rebalancing strategy, can take advantage of volatility and actually be an enhancement to long-term investors. It also provides an opportunity for tax-loss harvesting and an improvement for after-tax returns.”

Royce’s Gannon says advisors and investors need to keep their focus on risk in moments of volatility.

“Going forward, investors need to think about underlying fundamentals — companies that can generate pre-cash flow earnings and have good balance sheets,” Gannon says, while expressing concern about companies that are over-leveraged. “You need to think about those things more and more from a risk perspective going forward. Thirty-nine percent of the Russell 2000 has no earnings at the end of the quarter. That is a powerful statistic. Part of the volatility we are seeing in the markets speaks to active managers who understand their businesses.”

Next: Investor Myths about Volatility

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Tags:  Investment strategies , Portfolio management , Behavioral finance

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