Staying calm in volatile markets

Published December 14, 2011

Short-term losses and volatility are inevitable and investors have to live with them rather than be stifled by them, writes PETER BROOKS

THE choppy markets of the past few months may have made investors feel like they were reliving 2008 all over again. The bad news is that spikes in market volatility appear to be here to stay. The good news, however, is that there are ways to navigate safely through such times by purposefully managing our responses.

Higher volatility usually comes with higher levels of investor discomfort. Many investors consider pulling out of falling markets while those who see a buying opportunity can find it difficult to commit due to fear of mis-timing the purchase.

If higher volatility becomes the new norm, it is important for investors to better understand and take control of their investing behaviour. There are three easy strategies investors can adopt to increase their comfort in difficult markets: (i) keep the correct perspective of time horizon; (ii) rebalance assets; and (iii) keep an investment diary.

Strategy 1: Keep the correct perspective of time horizon

An investor attempting to perfectly time markets dominated by sentiment is unlikely to succeed. When asked how clients know they won't get caught by another big drop in the markets, I tend to give a very honest answer - you don't! Volatility and short-term losses are inevitable and you have to live with them rather than be stifled by them.

All of us have long-term financial goals, yet we often assess our progress towards them over short horizons. The more frequently you monitor your portfolio, the more risk you will perceive. This sense of greater risk can lead to irrationally conservative portfolios.

Think about what you would observe if you were to watch the markets closely. On a second-by-second basis, you will see prices move up and down with no apparent pattern. Obviously, that is an extremely short investment horizon that no private investor would use.

However, at monthly assessments, you would see losses on an equity portfolio (MSCI World) about 40 per cent of the time. Extend this out to annual horizons and you can expect to see losses about 25 per cent of the time. Clearly, how often you check your portfolio can lead to different perceptions of the amount of losses you are experiencing, impacting your stress levels.

It is helpful to simply check your investment valuations less frequently so that you do not over-perceive risk - after all, it is the actual risk of your portfolio that matters. This longer-term monitoring is a useful strategy for those with low composure who typically find it difficult to stay invested. It will mean that any trading decisions are not based on misperceptions of your actual portfolio risk.

Strategy 2: Rebalance your assets

The second strategy you can employ would be to rebalance your assets. This simple strategy is often neglected during times of stress because it can be emotionally difficult to commit to.

The process of rebalancing means that you will sell assets that have performed well and have become a larger part of your portfolio. You then use the proceeds to buy the assets that have performed less well.

It sounds simple until you have to execute the trades. Committing to sell better performing assets at times of turmoil is difficult. It seems almost illogical to increase exposure to the assets that are getting pummelled in the markets. If traded sensibly, though, this strategy will beat a buy and hold strategy, and massively outperform anyone who sells falling assets because of fear. The important thing is to commit to rebalancing frequently and stick to it.

Strategy 3: Keep an investment diary

The third good investing habit we would recommend is to keep an investment diary to help you stay focused on your rationale. By holding an asset at any point in time, you are implicitly assuming that it offers among the best risk-reward trade-offs available to you based on your expectations of the future and your other existing holdings. Any past gains or losses are not relevant to this decision (capital gains taxes aside) since your returns are determined in the future - not the past.

Keeping an investment diary is one way that you can help yourself. If you write down the rationale for the investments you make or don't make, then in times of stress you can read your original rationale and determine whether anything has fundamentally changed - or if it is only your stress levels that have shifted.

Imagine that three months ago you invested in Stock ABC and you wrote in your investment diary your reasons for making that particular investment. Let's say Stock ABC today is trading 20 per cent below your purchase price, and you are feeling anxious.

If you re-read your investment rationale and agree that it still holds, then you should be more comfortable holding on to Stock ABC. You may even consider buying more if you feel that the long-term prospects are unaltered and the fall has been driven by sentiment.

If you re-read your investment rationale and feel that the prospects for Stock ABC have changed, then you should ask yourself whether you can build a case for adding it to your portfolio now if you didn't own the stock. If you cannot convince yourself that you would invest in that particular stock at that point in time, then you should consider if there are better opportunities elsewhere. This approach will help you stay focused on your investment rationale and not trade on short-term moves.

While it is difficult to dramatically improve your position in the short term relative to your long-term goals, attempting to time volatile markets or becoming fearful and sitting on cash in the short term can drastically decrease your chances of achieving your investment goals.

Remember that although we all live in the here and now, our investment objectives are rarely realised in the present. Keeping the correct perspective and developing good investment habits will help you be a better investor.

The writer is head of behavioural finance, Asia Pacific, at Barclays Wealth. He holds an M Sc in economics and econometrics, and a Ph D. in behavioural and experimental economics from the University of Manchester. Barclays Wealth is the wealth management division of Barclays.