Investors shun Europe amid fears the Greek debt crisis will spread. Across the Atlantic, Wall Street suffers a gut-wrenching 15-minute dive because of a suspected computer snafu. What's wrong with markets?
The alarm over sovereign risk and technical malfunctions has certainly sparked renewed volatility in markets. But amid all the learned analysis and soul searching, it's worth reflecting for a moment on the long-term view.
It is now only a year and half since the collapse of Lehman Brothers had markets staring into the abyss. After several years of extraordinarily low volatility when nearly all the focus was on return, investors were reawakened rather rudely to the notion of risk.
The sudden spike in volatility—and the preceding long lull - can be seen in this chart, which records the performance of the Chicago Board Options Exchange Volatility index, a yardstick of investor anxiety.
This volatility was also reflected in ordinary stock prices. The US share market in 2008 suffered its second worst performance in eight decades. For the Australian market, it was its worst year on record; in Canada, the worst since the Great Depression and in Europe the worst since records began.1
The turnaround in sentiment from March 2009 was just as stunning, with major indices registering their best performances in years. In Europe, the broad market registered its biggest annual gain in a decade, in Australia in 16 years and, in the US in 20 years and in Canada in 30 years.2
So the performance of markets in the past two years has been extreme by historical standards. But the important point for investors is to note that over time, the positive return years from equities have outnumbered the negative and that investors who can bear the risk of stocks and stay committed through these various periods are rewarded for their discipline.
This chart shows the historical distribution of US equity market returns since 1926. The performance years are stacked in order of return range, with the down years in red and the up years in blue. The past two polar opposite years are in black. As you can see, the positive years over this eight-decade period outnumber the negative by a factor of almost three to one.
So investors may feel legitimately worried about the current sovereign debt strains in Greece or sudden computer-driven volatility in US stock exchanges. But it's important to understand that markets have a way of working through these things and rewarding those who over the long term risk their capital.
Saying markets work doesn't mean they don't make mistakes from time to time and are perfectly efficient. But these mistakes make less difference the longer your horizon. What matters ultimately is that markets are extremely competitive, and absorb new information almost instantly.
Trying to second-guess how markets might move in the next day or month or year tends to be counter-productive, because no-one knows the future.
We can deal with this volatility through diversification and by taking only those risks we feel comfortable with, while noting that risk and return are opposite sides of the same coin.
Whether ancient Greek or modern geek, the language of long-term investment remains the same.
1Closing Stock Market Indices, Reuters, Dec 31, 2008