Monthly Commentaries

Volatility returns to normal – July, 2007

The summer months usually see quiet markets and very little news. This year the markets were anything but quiet. The equity markets shed approximately 2.5% over the month with the bond markets recouping most of their second quarter losses. It is likely that the volatility in all markets will continue. Let's look at recent market moves from a historic perspective. At its worst point the Dow Jones was down over 500 points in a single day in July. This might seem like a huge move but on a percentage basis (-3.5%) it ranks as only the 698th worst day in the last 100 years. Equity market investors have experienced much worse single-day declines in the past. In fact, percentage moves of over 6% have occurred with regularity. Coming from a period of relative calm the recent moves are unsettling but not abnormal.

During the past 5 years the volatility in all markets continued to move lower, a trend that is likely at an end. (Volatility refers to the size of price swings occurring in a market). Accompanying this lower volatility was an equity market that moved higher without much of a setback – making the bull market of the past 5 years one of the least volatile in history. This decline in volatility was seen among many investors as a permanent move, and resulted in money pouring into extremely risky strategies. Over long periods, equity markets produce higher rates of return than bonds or treasury bills. In order to achieve this higher rate of return, investors must shoulder the inevitable price swings that take place. In other words, investors buy higher long-term returns through assuming risk. It is the risk side of the equation that investors have grown complacent about.

In July we saw a number of hedge funds down 90%, bankruptcies in corporations specializing in mortgages and large losses by institutional investors in asset backed securities. All of these losses occurred because not enough focus was placed on risk. The returns were the only thing that investors cared about. At Toron we focus heavily on risk. Each equity investment, and its inclusion into a portfolio, is carefully examined from a risk perspective. Our experience over the past 25 years has taught us always to manage risk rather than be wishful about returns. Arthur Heinmaa, CFA