Some Dos and Don’ts in Dealing With Market Volatility

In our experience, when market corrections (short, sharp, sentiment-driven -10% to -20% declines) strike amidst fearful headlines—like the present scenario involving Ukraine tensions—many investors feel an urge to do something. But for investors seeking long-term growth, we think reacting to short-term volatility is usually counterproductive. It is possible portfolio performance during—and investors’ reactions to—volatile spells may reveal some weaknesses worth considering, but we find this is best accomplished in a measured, forward-looking manner, not a knee-jerk move when stocks are falling. With that in mind, here are some dos and don’ts we think can help investors get through a difficult stretch of headline worries and rocky markets.

Do: Above all, in our view, investors should keep a longer-term perspective that prioritises their asset allocation—and the reasons for it. We think investors’ asset allocation—the mix of stocks, bonds, cash and other securities in their portfolio—should be based on their long-term goals, time horizon, ongoing cash flow needs and comfort with volatility. In our view, bouts of negativity alone shouldn’t cause investors to veer from a correctly designed allocation, since it should be likely to help them reach those goals over time regardless of near-term ups and downs along the way.

Keep in mind what an asset allocation’s components are there to do. Cash, in our view, is there for near-term cash flow needs, emergencies and known, upcoming purchases. Our research shows bonds reduce the magnitude of portfolio swings and, therefore, the likelihood of having to take scheduled withdrawals after a large drop.^[i] To us, stocks are for long-term growth, which is the reward for their higher expected short-term volatility.^[ii] We think it is beneficial to blend these to work in concert toward investors’ long-term goals.

In our view, veering from a correctly selected asset allocation is perhaps the biggest risk investors can take, as it moves them off a strategy designed to reach their long-term goals. Now, if an investor’s goals have changed, a different asset allocation may be in order. But that should be unrelated to volatility, in our view, unless their relatively low comfort with volatility is leading them to change return expectations. That is a valid consideration, but one we think investors should consider carefully, not necessarily in the heat of the moment.

Do: Distinguish between normal volatility and bear markets. In our view, short-term volatility is unpredictable and includes corrections that can occur for any or no reason—and often do occur during bull markets (extended period of overall rising stocks). To us, these typically swift market moves call for calm—we aren’t aware of anyone with a proven history of timing them successfully. This contrasts with bear markets, which are typically long, fundamentally driven declines exceeding -20%. Unlike corrections, we think it is possible to identify bear markets early on and avoid some downside.

We think positioning for a bear market should be a forward-looking decision—not a reaction to past declines. In our view, investors benefit from doing so only if they can identify a bear market before the bulk of the downside has passed—when they see a strong likelihood of substantial further declines. In our experience, this can manifest in one of two ways: one, when investors are broadly euphoric and, hence, blind to deteriorating economic conditions. And two, when a huge but broadly ignored negative development capable of erasing a few trillion pounds from global economic activity looks very likely to materialise. Here, we think “broadly ignored” is the key—risks everyone discusses are probably reflected in prices already.

Based on our study of market history, bear markets usually start gradually with rolling tops, which we think lulls many into complacency. We find bear markets generally don’t announce themselves with big, sudden drops that spook everyone. Our research shows about one-third of a bear market’s decline occurs during the first two-thirds of its duration, with the bulk of its decline in the last third. We think the slow start is what makes it possible to cut out a chunk of the downside.

Note though, we think a properly selected asset allocation is one that can help investors reach their goals whether or not they avoid bear markets. We don’t think participating in a bear market is desirable, yet bull markets always follow bear markets, and stocks’ long-term returns include all the bear markets along the way.^[iii] Therefore, we don’t think being invested in bear markets is likely to put long-term growth out of reach provided people also participate in bull markets, which far outweigh bear markets in time and magnitude.^[iv]

Do: Check portfolio diversification, which can help counteract unforeseen circumstances, in our experience. We think this means avoiding being overly concentrated in any one security, sector or country. It is always possible to be wrong. Concentration based on a mistaken supposition could be a severe setback. We think staying diversified makes sense in either rocky or calm periods, but viewing a pullback as a stress test can help uncover areas to address.

To assess diversification, compare portfolio holdings against a good benchmark—a broad, market-capitalisation weighted index with a long performance history, such as the MSCI World Index. (Meaning, an index whose constituents are weighted according to their total market value.) In our experience, portfolios whose returns are down (or up) much more than their benchmark are often a sign of possible misalignment. To pinpoint potential problem areas, check sector and regional weightings aren’t far out of line with the benchmark’s composition. If using the MSCI World Index, you can find its sector and country weightings on MSCI’s free, publically available fact sheets. These should also include the index’s largest securities’ index weights, which you can use to see if you have over-concentrations at the company-specific level. In our view, a weighting that is more than a few percentage points higher than the company’s index weighting may be a sign of excess risk.

Don’t: Buy low-volatility products designed to dampen market swings, as they offer only limited protection, according to our research. In our view, buying a low-volatility product when markets are enduring a correction could amount to paying a premium for something that might not work as hoped—and, even if it does, it would likely limit returns in an up market. We think the momentary peace of mind such products may provide isn’t worth a potential detraction from long-term returns.^[v] There isn’t any magic product with high, equity-like returns that aren’t commensurate with its risks—a point to always remember when it comes to investing, in our view. We think near-term volatility is simply the trade-off investors who need equity-like long-term returns will have to make.

Don’t: Dive into supposed safe havens; we think their purported risk-mitigation capabilities are overrated and can come with other risks. Similar to products marketed as portfolio protection, in our view, alleged safe havens like gold, real estate or other assets that many commentators we follow say will hold their value in tough times often don’t deliver. Based on our research, they can fluctuate as much as or more than a mix of stocks and bonds, without contributing anything to investors’ portfolios.^[vi] Also, they can be illiquid (difficult to sell when needed), adding to investment risks, according to our analysis.

Avoiding volatility at all costs is antithetical to the very concept of investing, in our view. We find a more helpful way to look at the markets’ sometimes wild gyrations is to reframe them: Short-term volatility is the price investors who need equity-like returns for some or all of their assets to reach their investment goals pay for long-term returns.