By Iain McGowan. Head of Fund Proposition, Scottish Widows.
Last year, for the second year in a row, all major asset classes delivered positive returns. The best performers were emerging and developed market equities.
Asset prices have been supported by a parallel increase in economic growth around the globe, low inflation and support from many central banks in the form of low interest rates and the maintenance of quantitative easing.
All-time highs with low volatility
Into 2018, many equity markets have continued to set all-time highs. And this increase has been accompanied by unusually low levels of volatility.
According to the VIX index, there has recently been only a minor rise after record levels of low volatility. VIX gauges the volatility implied by options on the S&P 500 Index in the United States; but implied volatility in the FTSE 100 and MSCI World indices are also near rock bottom.
More progress forecast
The general economic backdrop is as buoyant as it has been at any time since the global financial crisis. Many major central banks and supranational bodies such as the IMF forecast further global economic progress this year.
The lack of volatility suggests investors are reassured by the simultaneous presence of strong growth and low inflation. Even political tensions, such as strained relations between the US and North Korea, have barely affected the advance of stock markets.
Low volatility: an unlikely long-term prospect
A lack of volatility is reassuring for investors, but it is unlikely to remain at such levels in the long-term.
Nevertheless, short-term volatility isn’t an issue for many investors. Diversified portfolios and long-term investments mean a return to more typical levels of volatility is manageable. It can even offer the opportunity for investors to benefit, for example, from pound-cost averaging.
When contributions become withdrawals
Once investors begin to withdraw from, rather than add to, their investments, an increase in volatility can raise particular problems.
While in accumulation, investors can drip-feed money into investments – buying when asset prices are falling as well as rising to generate long-term growth. But in retirement, factors such as “volatility drag” and “sequence of return risk” can undermine the sustainability of a drawdown income.
Volatility drag describes how a fall in the value of a portfolio is hard to restore. For example, a 10% fall in a pension pot’s value would require an 11% rebound simply to return to the starting value. If income continues to be withdrawn during this correction, an investor would need an even larger rebound.
Some investors in pension drawdown can stop withdrawing money from their fund and rely on other sources of income while waiting for a market recovery. But this will not be an option open to all investors.