Does Market Volatility Require Investment Action?
One of the most frequently asked questions we receive from clients over an entire business cycle is “What are we doing in the portfolios when markets decline?”
Interestingly, our clients ask the question from both ends of the investment spectrum. Some clients ask the question because they believe that a market decline should provide an opportunity to purchase stocks as they have now become “cheaper”. Others ask this question in terms of whether the market decline is a sign of “bad things to come” and whether we should be selling securities. The real answer is that neither is the right approach. In this memo, I would like to discuss market volatility and the information it does/does not provide. I would also like to discuss in detail our investment discipline and why market movements don’t necessarily signal investment actions for FAI portfolios.
Market volatility can occur for many reasons.
Economic softness, global turmoil, natural catastrophes, poor business fundamentals, valuation bubbles and taxes/tariff s, just to name a few. However, investors should not be looking to market price changes for information. Market price movements are a by-product of true value creation from the underlying companies that comprise the market. Because of this, market declines are only a symptom of true value, not the measurement of true value.
One analogy that I believe all investors can understand is a medical check-up.
When an individual (market) goes to see the doctor, one of the ﬁrst things the nurse does is take the patient’s temperature (market price). If the patient displays a fever (market decline), the doctor doesn’t stop there with his/her analysis and just treat the fever (buy/sell stocks). On the contrary, the fever (market decline) is just a measurement tool to determine if the doctor needs to go deeper in the analysis to understand why the fever exists (reason for market decline), before the patient might receive treatment (action in portfolio). In most cases, if the patient has good health habits, receives the required vaccinations, exercises regularly, improves their diet and practices good hygiene these should help create defenses to outside forces that might expose the patient to health risks.
Our goal at FAI is to practice these “good health habits” in client portfolios and create defenses to a market correction.
We apply multiple tests to your portfolio to understand whether action is warranted, starting well before a market correction occurs. Many of the tests we preform are trying to estimate the likelihood of a market sell-off. Some of these tools include, using market valuations, business fundamentals and economic conditions to measure how probable a decline might be.
We also regularly research and analyze individual securities for valuation and business fundamental changes. Finally, we conduct a stress test across the entire portfolio to measure exposure/downside risk in case of an impactful market event.
All of this analysis is an ongoing exercise to access the risk of a large market dislocation and protect the portfolio from these risks.
These tools are also used to help uncover fruitful investment opportunities in all asset classes that may avail themselves and allow us to invest more of the portfolio in these specific opportunities. Because all of these tools are used daily/weekly/monthly, we don’t wait for a market decline to position the portfolio in its best risk/reward allocation. We change our portfolio positioning to always reflect our best market analysis and predictions. Most market dislocations do not off er us any new information at all because we have already performed a much deeper diagnosis. So, the next time the market sells off , be assured that if an action is needed in the portfolio that it will be completed, and most likely it was already implemented before the event occurred.
Thank you for your support of FAI.
Curtis R. Gross, CFA
Chief Investment Officer