Holding your nerve

• Financial markets have been particularly volatile this year, what with the war in Ukraine contributing to surges in commodity prices and a cost-of-living squeeze hitting economic prospects.
• If you are concerned about being invested when markets are particularly volatile, it may be time to consider the idea of ‘anxiety-adjusted returns’. In deciding on appropriate portfolios allocations, this concept looks at the performance that an investor is comfortable with for a given level of emotional pressure.
• Holding portfolios for the long term, through market cycles, is usually the best approach. In other words, it is time in the market rather than market timing that tends to be key to long-term success.
• A well-diversified portfolio can mitigate the impact of tail risks and reduce the volatility of returns. In the face of uncertainty, and risks which we do not even know about, the best protection is probably to invest in a range of assets.
• Periods of extreme uncertainty in markets generally offer more attractive entry points for investors with a long horizon. Indeed, although spikes in uncertainty occur frequently, they need not stop an investor from reaching their long-term goals if they can focus on their ultimate goal.

It’s been an unusually volatile start to the year for many financial markets, as the war in Ukraine rages on and a cost-of-living squeeze hits economic prospects around the world. At such times, a common mistake can be to act too impulsively and sell investments. What can investors do to try and avoid such urges?

Beware of your emotions

Investors’ emotional time horizons can shorten when markets are extremely volatile. This might seem to make investing appear riskier, as the probability of making a loss is higher in short periods. As a result, actions may be taken in the hope of reducing short-term risk, but which result in diverting from the plan to protect and grow wealth over the long term.

Making rash investment decisions when you are particularly emotionally stressed can worsen behavioural biases, possibly reducing long-term returns. Bear markets are often the most challenging for investors. Not so much for any large falls in market valuations as such, but due to the risk of taking poor decisions that have lasting consequences.

Focus on what you are comfortable with

If you are concerned about being invested when markets are particularly volatile, it may be helpful to turn things on their head and look at what you want. The concept of ‘anxiety-adjusted returns’ looks at the performance that an investor is comfortable with for a given level of emotional pressure.

Holding portfolios for the long term, through market cycles, is usually the best approach. In other words, it is time in the market rather than market timing that tends to be key to long-term success. In doing so, phasing-in investments may be one way to achieve this while feeling more comfortable doing so.

Avoid being overly cautious

When uncertainty is high, and consequently investors may want to adjust their portfolios, being aware of the impact the changes might have on portfolios is crucial. The key is to allocate enough to risk assets so as to not alter the long-term returns potential of portfolio holdings. 

Hedging strategies are one such approach. Use of put options, foreign exchange, and structured products are among ways available that may protect against falling markets.

Another option is by adopting a core-satellite approach. This can allow an investor to strike a balance between focusing on achieving long-term goals, while making tactical tilts in the short term. The bulk of the returns are generated by the core asset allocation, and a smaller satellite portfolio allows for more opportunistic trades.

Diversification, diversification, diversification

A well-diversified portfolio can mitigate the impact of tail risks and reduce the volatility of returns. In the face of uncertainty, and risks which we do not even know about, the best protection is probably to invest in a range of assets.

There is also an additional emotional benefit from diversification. By insulating a portfolio from volatility, an investor may protect themselves from the dangerous emotions that volatility can induce, which may make it easier to hold onto investments when things do not go to plan. In doing so, having some illiquidity in the portfolio, perhaps by investing in private markets so that holdings cannot be sold quickly, can support good long-term investment behaviours.

As humans we like familiarity, which is often mirrored in investment portfolios that are biased towards a particular region, or asset class. Familiarity is typically equated with lower risk. However, having a home-biased portfolio, and so making it more concentrated, can actually increase risk.

The dangers of holding cash

Like rabbits caught in headlights, fear of making losses and rising risk aversion may see investors miss out on opportunities to add to or maintain risk allocations when markets are particularly volatile. Indeed, the urge to hold more cash at such times is dangerous.

For instance, research of UK asset returns since 1899 shows that by investing in UK equities for two consecutive years, the probability of outperforming cash and UK government bonds is 69%. Over a ten-year period, this rises to 91%.

Remember to look for opportunities

However uncertain and worrying events might look, potential investment opportunities arise in different market conditions. Times of extreme uncertainty in markets generally offer more attractive entry points for investors with a long horizon.

Indeed, long-run investment returns would be significantly lower if it wasn’t for tough times. Such periods occur frequently, but need not stop an investor from reaching their long-term goals if they can focus on their ultimate goal.