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The myth

When stock markets become highly volatile, you should run for shelter.

The reality

Volatility is not an accurate reflection of whether you should be in or out of equities.  Instead, you would be much better off ignoring volatility and invest based on fundamental company valuation measures.

Harry Markopolos and Dan di Bartolomeo were the global investment experts who first spotted problems with fraudster Bernie Madoff’s performance in 1999. Dan encapsulates risk as not being about markets going up or down, or major geopolitical issues. Rather, he says: "It’s what you don’t know that can hurt you."

The average investor tends to view volatility – and thus the risk of investing in equities – superficially; i.e. the stock market’s ups and downs. On this basis, when the going gets tough, investors tend to immediately disinvest from equities into other "safer" investment vehicles, predominantly cash, even though these may not meet their investment needs in the longer term.

However, there is no consistent correlation between volatility and stock market returns. In fact, rising volatility in 2007/08 was followed by steeply rising returns. But when volatility subsided in 2005, returns also picked up nicely 12 months later.

Reacting to volatility will cost you dearly

So instinctively reacting to volatility is unlikely to hold you in good stead in the medium to long term. In fact, it is likely to prove extremely costly – particularly if you try to time your entry into or exit from the market based on whether the market is volatile or not.

There’s substantial evidence that shows even the most sophisticated and knowledgeable investor is unable to predict where the markets are going most of the time.

You are much more likely to make money by investing based on what assets are actually worth; buying them when they are not popular and selling when they are. While this goes against the grain for many investors, investing according to a value investment strategy (such as that followed by SIM) has been very successful over the longer term.

If you had invested in the All Share Index in 2003 when its price-to-book ratio was low, you would have experienced a period of attractive returns, as measured by the ALSI’s return on equity thereafter.

Value-based strategies work

However, if you had invested when price-to-book multiples were above 3x, between early 2006 and late 2007, you would have suffered a steep drop-off in returns.

This snapshot is in line with the significant outperformance of value-based investment strategies over time which shows just how substantially value has outperformed other investment styles since 1997.

A market sensitivity style, which captures the shares that are most sensitive to beta (the movement in the underlying market), is the second worst performing style and, after 17 years, investors following this style would have seen their capital eroded.

During the period value also outperforms a momentum style, which encapsulates investment decisions driven by whether a share is on its way up (popular) or not.

Article published courtesy of Sanlam Investment Management.