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Share Market Volatility - ABC Radio Material

In these times following a sharp fall in sharmarket values - and at the moment Australian shares have fallen around 15% in value sinceNovember - you often see a lot of experts saying that people should not sell shares because 'they are a long term investment'. While this is the case, I am not sure if this is such a sophisticated argument. At some level I don't quite understand it - sure shares might be a long term investment, however if I think they are going down in value why wouldn't I sell?

This part of the article looks in more detail why this might be a poor time to sell shares, and a reasonable time to buy them.

These reasons include:

1/ The fact that bad news is now priced into the shares - a possible recession, falling US housing prices and the difficulty companies are having borrowing money. It is better to buy when some bad news is priced into the market, rather than when it is all good news and therefore any bad news sends share prices tumbling (as we are seeing now).

2/ The earnings of shares compared to their price are now very strong - at 19 year lows. It is a better time to buy/hold shares when earnings are strong compared to their price.

3/ There are a lot of emotions in the market (mainly fear). We have to be careful about making emotional reactions - many people suggest we should do the opposite. A famous Warren Buffett quote is 'be fearful when others are greedy, and only be greedy when others are fearful'.

4/ There is a risk in selling shares, and that risk is that you will get less than the average return because you are out of the markets. A study from the US, by Dalbar a financial research firm, found that investors in United States share funds received a return equal to one third of the return from the market because the kept buying and selling.

5/ Selling can be very expensive. Not only do you have brokerage, you also have the tax consequences. After such a great period of market returns, many people will be paying large amounts of capital gains tax on share sales.

In putting forward a long term plan for including shares in an investment portfolio it is important to focus on how sharemarkets work - and the following five 'realities of how sharemarkets work' outlines the basics of this.

5 Realities of How Sharemarkets Work

Reality 1 - Growth Assets Such as Share Investments and Property Investments are Volatile

There are two groups of investments used in portfolios. The first are 'defensive' investment assets which include cash and high quality fixed interest investments such as Australian government bonds. The second group are generally referred to as 'growth' investment assets such as property and shares (both Australian and international). The returns from these asset classes are volatile. In the last 30 years:

  • Annual Australian Share Returns have ranged between -29% (1982) and 74.3% (1980)
  • Annual Global Share Returns have ranged between -23.5% (2002) and 72.7% (1983)
  • Annual Listed Property Returns (Aust.) between -2.8% (1988) and 41.3% (1987)
    (Year to 30 June 2007, Vanguard Investments)

Reality 2 - Growth Assets Have a Higher Long Term Expected Return

Given that a good cash account provides a rate of return of above 6% in the current environment, why would you invest in growth assets at all? The answer to this is that growth assets have a significantly higher expected return than a cash or fixed interest investment.

  • Average Australian Sharemarket Return since 1971 13.8% a year
  • Average Global Sharemarket Return since 1971 13.6% a year
  • Average Listed Property Return since 1980 15.3% a year
  • Average Cash Rate of Return since 1971 9.5% a year
    (Year to 30 June 2007, Vanguard Investments)

Reality 3 - Volatility CANNOT be Avoided

Wouldn't it be great if we could avoid the down times of investing in shares and property, and only invest in them when they are increasing in value? Well it would be good, however it does not happen. As an example, let's look at the biggest crash in recent Australian investment history, the 1987 sharemarket collapse where shares fell in value by more than 30%. Just prior to the 1987 collapse, more money that ever before was invested in the Australian sharemarket. The collective wisdom was that this was a better place than ever before to invest money. The collective wisdom was absolutely wrong, as the sharemarket fall showed.

Dalbar, a US financial services firm looks at the actual return investors in the US received from their managed fund investments. Over the 20 years to the start of 2006 they found that US managed fund investors received a return of just under 4%, against a market average return (S & P 500) of 11.9%. Why did managed fund investors receive such a terrible return? Because they were trying to pick and choose when to invest and therefore avoid volatility - which seriously damaged their ending investment returns.

Reality 4 - Growth Assets CAN Have Negative Periods of 5 Year Returns

The collective wisdom in the financial services industry is that if you hold a growth investment for 5 years then you will get a positive investment return. This is easy to disprove - currently most global share investments (currency unhedged) are showing negative 7 year returns. Growth assets can have periods of negative returns for period s longer than 5 years.

Reality 5 - Asset Allocation and Careful Income Planning is your Key Tool in Managing Volatility

Using a mix of growth assets in a portfolio, including Australian shares, global shares, listed property trusts, global listed property trusts and emerging market funds, smoothes - but does not eliminate - the volatility from growth assets. Setting aside a number of years worth of cash needs in fixed interest and cash investments means that you will not have to sell growth assets in a market downturn.

Cash and fixed interest investments, which do not rise and fall along with the general market, also dampen the volatility of an overall portfolio. The cash and fixed interest investments are replenished by the growing stream of dividends and distributions from the growth assets - eliminating much of the need to sell growth assets at any time.