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A Volatile Stock Market Is Nothing to Fear

On Sunday, talks between the leaders of Greece and other nations within the Eurozone in relation to Greece’s repayment of its debts broke down and led to sharp drops in many stock markets around the world.

In Asia, Japan’s Nikkei 225 Index, Hong Kong’s Hang Seng Index, and Singapore’s own Straits Times Index (SGX: ^STI), had fallen by between 1.2% and 2.9% on Monday. Then, when the US market opened, it too saw its benchmark indexes – the Dow Jones Industrial Average and S&P 500 – decline by at least 2%.

On Tuesday however, stocks started climbing. The Straits Times Index gained 1.1% that day and as of the time of writing today (10:30 am), the index has put on a further 0.55%. Such volatile swings might put fear into investors who might be wondering about what will happen next.

But here’s the thing, the stock market has always been volatile – and better yet, there’s nothing to fear.

I’ve looked back at historical data for the Straits Times Index going back to 1993 to find the maximum drawdown that the index has experienced in each year; maximum drawdowns are the worst peak-to-trough losses that have occurred for any timeframe you’re looking at. Here’s what I found:

Maximum drawdown for Straits Times Index, 1993 - 2014

Source: S&P Capital IQ

From 1993 to 2014, the Straits Times Index has seen a maximum drawdown of 10% or more in 19 years. Those losses can be painful, I kid you not.

But, the index has also more than doubled from 1,531 points at the start of 1993 to 3,336 today. Despite frequent short-term pains, the index has still delivered long-term gains. If dividends were included, we could even reasonably expect the Straits Times Index to have achieved annualised total returns of around 6.8%, which isn’t too shabby at all.

It’s the same story with individual stocks. Healthcare services provider Raffles Medical Group Ltd (SGX: R01) can be a great example. Over the past 10 years since the start of 2005, Raffles Medical’s shares have made incredible gains of 945% in price to S$4.60 today. But over that period, the firm had seen its shares clock a daily loss of 2% or more in 193 days, or more than 7% of the time.

Here’s how Raffles Medical’s maximum drawdowns look like in each year from 2005 to 2014:

Maximum drawdown for Raffles Medical Group, 1993 - 2014

Source: S&P Capital IQ

I trust it’s obvious to see that Raffles Medical, despite being a massive long-term winner, wasn’t immune to the experience of having its shares get hacked every now and then.

The stock market falls and it also rises – it’s just the nature of the beast. In the short run, stock prices can take on a life of their own. But over the long run, it’s the performance of the business that matters. To the latter point, the chart below shows how Raffles Medical’s profit and free cash flow – two good measures of the underlying economic value of a company – has been steadily rising since 2005.

Raffles Medical's net income and free cash flow growth

Source: S&P Capital IQ

Benjamin Graham, the intellectual father of value investing, was believed to have said that the market is a voting machine in short-term, but a weighing machine over the long-term.

The volatility we see daily and over shorter-term time frames is a consequence of the voting machine, where the popularity of the market and of individual stocks might change at a whim. But as time passes, the true strength of the underlying business should shine through and that is when the weighing machine takes over.

Yes. The market is volatile. But it need not be scary if investors have the right focus on the thing that really matters – the performance of the underlying business.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Raffles Medical Group.