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How to Win in Volatile Markets

Shocking. That was my reaction when I read an article on American Affairs titled “Private Equity: Overvalued and Overrated?” by investor Daniel Rasmussen.

This article you’re reading now is not about private equity, which refers to investing in private companies. What I want to touch on is the very important topic of investing behaviour in the stock market (I will share the importance of the American Affairs article shortly). It is what can make or break your investment returns.

Benjamin Graham, the godfather of the investing field, once said: “The investor’s chief problem—and even his worst enemy—is likely to be himself.” Graham was referring to the tendency for investors to sabotage their own returns because of poor behaviour.

I think the topic of investing behaviour deserves prominence today because we just experienced a bout of volatility in many stock markets around the world over the past few weeks. From a recent peak of 2,873 reached on 26 January 2018, the S&P 500 — the US market benchmark — fell by 10.2% to a low of 2,581 on 8 February 2018. Singapore’s own Straits Times Index (SGX: ^STI) fell by 6.4% from peak-to-trough over 15 days.

Smoothing Out Returns

In American Affairs, Rasmussen shared something that the Chief Investment Officer of the Public Employee Retirement System of Idaho — essentially the pension fund of the US state of Idaho — once said about investing in private equity funds (emphasis):

“We did know that our actuaries and accountants would accept the smoothing that the accounting would do. It may be phony happiness, but we just want to think we are happy. If [private equity] just gave public market returns, we’d be in favour of it because it has some smoothing effects on both reported and actual risks.”

The CIO of the Idaho pension fund would be happy to choose private equity over stocks simply because the former appears to be less volatile. This was shocking to me. As a CIO, I would have expected him to know better—that while stock prices are volatile, the actual economic worth generated by listed companies tend to be a lot steadier.

What Really Matters

Robert Shiller, an economist who won the Nobel Prize in 2013, once looked at more than 100 years of data on the US stock market. He wanted to know how stock prices moved in relation to changes in business fundamentals.

Source: Robert Shiller study

The chart above is the result of Shiller’s study. It plots how the US stock market actually performed from 1871 to 1979 (the solid black line) and compares it to how the index should have performed in that time frame if investors had perfect hindsight knowledge of how the index’s dividends had changed (the dashed line).

As you can see, while stock prices are volatile, the actual economic worth generated by listed companies tend to be a lot steadier.

Keeping Your Eyes on the Important Things

Warren Buffett once said:

“Games are won by players who focus on the playing field [the underlying businesses]—not by those whose eyes are glued to the scoreboard [stock prices]. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”

When the market becomes volatile and stock prices fall, it’s easy to become fearful and start selling. But if you actually do so, you would be exhibiting poor investing behaviour—you end up being your own worst enemy.

Business fundamentals tend to be far less volatile than changes in stock prices, as the Robert Shiller image above shows. In fact, some companies are even able to grow their businesses during the midst of horrible bear markets. A good case in point would be VICOM Limited (SGX: V01) and Raffles Medical Group Ltd  (SGX: BSL) – both companies managed to grow their profits substantially during the Great Financial Crisis.

If we are able to watch the right things (the business) when stocks are falling, I think it could be a soothing balm for our frayed nerves. As Buffett said, it is also how games are won.

[Editor’s note: A version of this article first appeared in the 24 February 2018 edition of Take Stock.]

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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 VICOM and Raffles Medical Group. The Motley Fool Singapore has a recommendation on Raffles Medical Group.