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The historical view

01/04/2008

Since its record high in November last year, the Australian share market has fallen as much as 24% on the back of ongoing problems in global credit markets and increasing evidence that the US economy is headed for recession. Naturally, when the share market undergoes such a significant pullback, investors begin to worry and often ask themselves if they should ‘get out’ while they still can.

But, while all signals continue to point to further market volatility in the short-term, history suggests that remaining invested at times like this may actually be a better option than ‘cutting your losses’ and getting out.

Volatility here to stay

Whether we like it or not, market volatility is here to stay. “Until recently,” says Stewart Brentnall, whose BT Investment Solutions team manages over $2.5 billion on behalf of BT investors, “Australian investors had benefited from nearly five years of relative economic and market stability and the strong investment returns that such an environment brings. “But, as the Australian market continues to evolve and it becomes more and more integrated with other (global) investment markets, it’s inevitable that we’re going to see greater levels of market volatility as a result.”

Some historical perspective

But, should investors really be worried by this? Stewart points to some interesting facts of history. Over the last twenty years or so, there have been at least ten major events that have had a significant impact on the level and direction of the Australian share market, starting with the Wall Street Crash back in October of 1987.

“Each of these events resulted in a sustained period of market volatility. But while these events may have caused great uncertainty at the time, history shows us that the Australian share market inevitably bounced back.” And this, according to Stewart, is what investors need to keep in mind whenever the market is subjected to the sort of volatility we’re seeing at the moment. “Too often,” he says, “investors get caught up in all the hype of short-term market movements and exit the market at exactly the wrong time.”

The long and the short of it

Consider the following two charts. “The first,” says Stewart, “shows the one year returns to 31 December for the Australian share market over a 50 year period from 1957 to 2007. As you can see, over the last 50 years there was a 1 in 4 chance of the Australian share market posting a negative return.”

S&P/ASX All Ordinaries Index – 1-year returns (%)

Now look at the second chart, which shows the rolling ten year returns for the Australian share market over the same 50 years. “You’ll notice that over each ten year period, the Australian share market failed to post a single negative return. Even for the ten years to 1987, which included the famous Wall Street Crash, the local share market still managed to post an average return of 24.4% per year.”

S&P/ASX All Ordinaries Index – rolling 10-year returns (% annualised)

Don’t try to time the market

According to Stewart, a serious mistake that an investor can make is to try to time their entry and exit in and out of the market. “Because the cycles in which investment markets move are not uniform and predictable,” he says, “it’s very difficult to forecast when a particular market will peak or trough. In reality, most of the biggest gains or losses in share markets are actually made in just a few trading days of each year. So, by moving in and out of the market, not only are you incurring additional costs in the form of brokerage and fees, you also run the risk of missing out when significant gains can be made.

According to Stewart, the same is the case if you are trying to pick the best performing asset class. “It often pays an investor to have a diversified portfolio of assets, which should guarantee that they have some of their investments in the best performing asset class at all times.”

As we wait to see whether or not the US economy can skirt a recession, we can expect market volatility to continue in the short-term. But, while we could yet see further daily market swings of 2% or more here in Australia, it’s important that investors maintain some historical perspective and focus on their long-term investment objectives rather than what’s happening in the market right now. “Remember,” says Stewart, “time is the friend of good investment decisions, and the enemy of bad ones.”