The origin of the idiom “Don’t stare a gift horse in the mouth” is ancient and unknown. It expresses the advice to not refuse something that is fundamentally good (“the gift”) while spending time finding fault with what is being offered (“the horse’s bad teeth”).
When confronting volatility in financial markets, investors are inclined to stare the gift horse in the mouth. They struggle to see through volatility for what it is: the opportunity to position for higher equity returns. Of course, investors do not want to be told that volatility is a gift when they have just watched the value of their portfolio decline!
Most investors abhor volatility and will gladly sacrifice returns to avoid it. But for those with a long-term horizon, this does not make sense. As Warren Buffett noted, he would always pick a strategy that could provide 12% compound returns over five years than one that promised a lesser but more stable 5% return. Most investors mistakenly prefer the more stable 5% return, especially in difficult times.
Volatility is usually associated with a disruptive market environment and investors seek to avoid these moments in financial history. From our perspective, volatility is the sign that one should prepare to buy. While it may not feel like it at the time, periods of high volatility are invariably the lowest risk moments to own equities because the “problems” are more widely understood. There is always the chance that stocks become cheaper still, but this is a short-term rather than long-term risk.
One corollary is to be well positioned entering the period of disruption. Volatility is irregular and unpredictable. The advantage of long/short investing, as well as other risk-adjusted alpha investments, is that they seek to avoid overexposure to equity downside.
Equally, this is why we adopt an incremental approach to adjusting our equity exposures. We do not want to jump 100% into our long exposures after a 10% pullback, when the final correction might be more like 20% to 30%.
Judging the context of a volatility cycle is critical. Good information, thoughtful analysis, quick but not impulsive reactions and knowledge of economic and social history are all important ingredients for getting it right. At moments of extreme fear, the power of daily price momentum and the passions of “the crowd” are important psychological influences upon all of this.
Extreme volatility is the sign that it is time to become a long-term investor again. Being bearish or cautious always sounds smarter than being bullish like staring the gift horse in the mouth. The advantage of a long/short strategy is that it weighs against the crowd and seeks the full upside of equities on an opportunistic basis.
For more information, see:Return to the Volatility Guide
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
Past performance is no guarantee of future results.
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
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Co-CIO, Senior Co-Portfolio Manager