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Simply Put

Dear volatility

November 07, 2017

The $64,000 question is: where on earth have you gone? There was a time when you’d visit the stock market more often and with greater intensity, when you’d get people to sit up and take notice. Lately you’ve been so quiet and mild mannered that we think some investors have been lulled into a false sense of security.

Considering the popularity of investment products promising low volatility, there are also investors who hope – heck, will even pay good money – to never deal with you again. Not everyone appreciates your wild swings based on the news of the day, or the weather, or for no apparent reason.

We’re different in that we embrace your erratic moods knowing they increase our chances of making our investors money. Understanding the value of the businesses we own means not having to worry about how you’re impacting their stock prices in the short term. We believe these businesses will eventually be recognized for their true worth and that helps us stay focused on the prize.

That said, we don’t ignore you day to day. Just the opposite. We try to capitalize on the price dips you instigate by buying more of our favourite businesses when they cost less. Because the higher the initial price tag, the lower the ultimate return.

On the flip side, we’ll sell a business if its stock price exceeds what we consider reasonable. Cliché alert: our goal is to buy low and sell high. And you help us immensely in that endeavour.

Sounds simple but we acknowledge it’s more difficult in practice. The following illustrates the flow of money in and out of mutual funds over time and how, as investment returns rise, so does the amount being invested. Conversely, when returns decline, flows dry up. In other words, investors tend to chase performance to their detriment, buying and selling at the worst possible times.

Source: Investment Company Institute, Morgan Stanley Capital International and Bloomberg LP. Average monthly rolling six-month net-new cash flow to U.S. equity funds (as defined by the Investment Company Institute). Total equity return based on one-year moving average of MSCI All Country World Daily Gross Total Return Index. MSCI World Index is a broad-based, market-capitalization-weighted index comprised of equity securities available in 23 countries from developed markets globally.

Moral of the graph is that, among other negatives, this leads to differences between overall fund returns and individual investor returns, a phenomenon called the “behaviour gap”. Unfortunately that gap isn’t in investors’ favour because they can’t handle downward fluctuations in their investments or fight their natural instinct to sell in an attempt to stem losses. How empowering for them if they could.

When (not if) you do reappear, our wish is for investors to succumb to a behaviour gap, but one that reflects their successes rather than failures. While we can do our best to provide strong long-term results, investors are in the driver’s seat in terms of avoiding the mistakes that keep them from enjoying those results. That includes facing you, dear volatility, head on.

Hope to see you again soon,

EdgePoint