Hello volatility, welcome back. It’s been a while.
As share market investors, we should appreciate that we’ve had it pretty good for several years. It’s hard to understate how smoothly world equity markets have climbed since things settled down after the 2007-09 crisis.
Since then, returns have been way above average while volatility has been way below average.
Profiting from a risky asset always involves a cost – the “price of admission.” That price is not just whether we get the long-term return we hoped for, but it’s also the ride along the way. And it’s this volatility that compels some of us to make bad decisions.
Volatility’s return is a source of discomfort for all of us as it forces us to pay more attention to near-term market moves, which is mentally tiresome. And it tempts us to make near-term decisions that aren't good for us. Sometimes, it’s hard to resist counterpunching.
Some basic tenets of behavioral finance can prove insightful at times like these. The goal is not to change your mental make-up – that’s impossible – but to appreciate that our hardwiring leads to some quirky behavior. Self-awareness can help us hedge bad decisions.
What's your plan?
Having an investment plan in which you are reasonably confident helps calm free-floating anxiety and address questions about what to do in reaction to events over which you have no control.
That is the easy first thing: Do you have a plan about your investments and overall financial outlook?
An investment policy statement can help map out the direction investments should take. It's also useful to have handy when anxiety starts to mount about the economy. You are prepared for contingencies and worst-case scenarios.
These are the questions your investment policy statement will answer:
What is your goal?
Pro tip: Quantify your goal if possible. For instance, I need $3 million when I retire in 30 years. Armed with this data, you can calculate the rate of return needed. That will dictate the level of risk in your portfolio -- or the extra amount you'll need to save to hit that goal if the level of risk is not feasible.
How long will you be investing in the share market?
Pro tip: The longer the holding period, the less the probability of losing money. Historically, there were no 20-year holding periods with negative returns.
What is an appropriate asset allocation plan?
Asset allocation is what financial professionals call spreading money around various types of investments, such as large-cap stocks, small-cap stocks and high-quality corporate bonds. It should be based on your goals, time frame and risk tolerance.
Pro tip: Think about worst-case scenarios, such as the recent financial crisis. Sharemarkets lost more than 50% between Oct. 1, 2007, and March 5, 2009. Some portfolios lost more than that and some lost less. Smart asset allocation and diversification can lower the risk in your portfolio and improve returns.
What is your process for rebalancing or selling investments?
Pro tip: Maintain a disciplined investment approach. Stay invested and reallocate your portfolio to its intended target allocations if they get out of range. Rebalancing may reduce risk and is an automatic way of buying low and selling high.
Planning short-circuits panic
There can be unforeseen and expensive consequences to blindly selling in scary market conditions, including transaction costs and opportunity costs. It typically costs money to buy and sell investments.
Selling low also locks in losses.
Trying to time markets in the short run is counterproductive, as the odds are against you. You have to guess right twice: when to get out and when to get back in. If you don't guess right, long-term returns will be compromised and short-term paper losses may turn into permanent ones.
Employing patience and taking the long view will help you get to the other side of market tumult battered but intact.
In times of duress, use market volatility as a gauge for your risk tolerance.
Here is a really important one. When market conditions return to calm, use your new found experience to fine-tune your approach to investing to be better prepared next time.
Don't worry, the market will tank again.