Weathering volatility

How investors can avoid turning short-term pain into lasting damage

We consider ourselves rational investors until we’re faced with losses. When markets become more volatile and the value of our portfolio drops, our “fight or flight” response kicks in, making us want to flee to less-risky investments. But divesting underperforming assets and locking in the losses can permanently impair your wealth, say the experts at

UBS Wealth Management

Americas.

“There’s a distinction between pain and damage,” explains Justin

Waring, UBS Investment

Strategist Americas. “Pain is what you experience when your investments go through large drawdowns and take time to recover. Damage is what happens to your portfolio if you lock in those losses by changing strategies in reaction to markets. If you give up on risky assets after a loss, they won’t have a chance to recover.”

Risk semantics

Making knee-jerk decisions, buying or selling on emotion, frequently changing the composition of your portfolio – these can all have long-term consequences for your wealth. Researchers who analyzed brokerage accounts for more than 66,000 US households between 1991 and 1996 reported 6.8 percent annualized underperformance for high-turnover investors compared to their low-turnover peers.

Part of the issue stems from how investors think about risk. “Risk tolerance” has become an industry-standard term and is generally defined as the amount of volatility you can psychologically withstand in your portfolio. But according to Waring, many people find it difficult to be realistic about their emotional limits or to simulate what it might feel like to lose money. “Risk capacity” is a less-used concept that is more specific to an investor’s specific goals. How much volatility can your portfolio withstand before you need to change your spending habits or compromise on your lifestyle? For example, if your portfolio drops 20 percent and stays there for five years, will you be able to maintain your current level of spending? Will you need to postpone retirement? Could you get by if you cut back on spending for a few years until your portfolio recovers? These are good conversations to have with your financial adviser.

Smart moves

Consider making an allocation to an emergency fund to provide a stable source of income that can meet your spending needs over the next three to five years. Maintaining a Liquidity strategy allows the rest of your portfolio to continue to appreciate – and you’ll have the financial flexibility to consider increasing your equity allocation during a bear market. The liquidity strategy might consist of cash and short-term bonds, and it may include an asset-based borrowing facility that you can use to meet cash flow needs. If you proactively set this up in good times, you’ll have a buffer against financial distress during a turbulent market, so that you can maintain your lifestyle and avoid turning “pain” into “damage.”

Waring notes that the bulk of transactions in a portfolio should be driven by process, not reaction. “Investing is emotional, and losses are hard to look at. Make a plan to weather the volatility of the riskier parts of the portfolio, and don’t focus on your paper losses.

“You should always have a strategic asset allocation in place,” Waring says. “Let your goals and your plan – not the markets – guide your decisions.”

To learn more, read the UBS Chief Investment Office whitepaper Managing a Liquidity strategy.

Everyone has a plan until they get punched in the mouth.” —Mike Tyson