Take a long-term diversified approach to guard against market volatility

WE HAVE seen considerable ups and downs in stock markets over the last few months. After a strong 2017, during which some markets hit record highs, and a robust January 2018, sharp falls in share prices reminded us all that equity investments are not without risk.

During the recent correction, the US stockmarket, as represented by the S&P 500 Index, actually fell by 10.2 per cent over nine days.

Such periods are particularly challenging for investors, not simply because we are witnessing a temporary decline in our wealth, but because it is in these environments – when newsflow is overwhelmingly negative and prominent – that we tend to make poor long-term investment decisions.

As human beings, we are naturally averse to losses. We are also biased to give greater consideration to events that have taken place most recently.

This means that sharp drops in markets over short time periods cause us considerable, and often undue, consternation. Even if our investment horizon is years – rather than months or days – our emotional response to difficult market conditions means that we can become incredibly myopic in our outlook, to the detriment of our long-term returns.

So how can we as investors better navigate bouts of unsettled conditions in financial markets. Or, in other words, how should we deal with volatility?

Given the ingrained nature of our behavioural biases this is not easy, but there are some key principles that we can use to guide us.

Taking a long-term view will allow investors to benefit from the effect of compound interest or returns as the investment grows over time

Avoid constantly checking the value of investments as that could lead to poor decisions.

Accept that, over a 10-year timeframe, volatility should be expected and should not have a significant impact on long-term returns.

It is crucial to remember that the best long-term returns are often obtained when investments are made during difficult periods for markets, when valuations are low.

Conversely, when things seem uniformly positive, investing at this point might mean an expensive entry point and be a prelude to lower future returns.

Avoid emotional decision making. How we feel can have an overwhelming impact on how we invest. If you feel particularly excited or fearful about an investment decision, it is often best to postpone it.

A simple rebalancing approach – selling investments that have performed well and reinvesting into those that have struggled – can be an effective and disciplined way of benefitting from market volatility.

Even though our instinct is to react to market volatility and make changes to our portfolio, doing nothing should be considered a viable option. Although this is often the most difficult choice, it can often be the correct one.

What else can we do as fund managers? We can ensure that our portfolio is comprised of a broad spread of different assets – shares from companies in different geographical regions and industries, bonds issued by governments or companies, property and currencies. In short, we can diversify in order to invest in a range of assets that behave differently to each other. We are then not reliant on the fortunes of one type of investment and this should help to smooth long-term returns.

Markets are inherently noisy and can be prone to sharp short-term moves. Losses in such periods are difficult to ignore, but often the decisions we make during these times, rather than the market moves themselves, have the greatest negative impact on long-term returns.

The best protection against behavioural vulnerabilities in such environments is to ensure we have a sensible long-term investment plan and a diversified portfolio supported by disciplined decision making.

This is, of course, no panacea, but it can materially improve our investment behaviour, particularly through challenging times.