Market volatility and uncertainty
INSIGHT ARTICLE |
Money. This simple five letter word conjures up many emotions from happiness to worry, from fear to greed. The media plays off these emotions with headlines that have recently contained the words “rout”, “global market sell-off” and “investor anxiety deepening.” Clearly, the beginning of 2016 was a difficult one for the global markets. It can feel terrible for investors as they see the value of their portfolio decreasing day after day. During periods of market volatility and uncertainty, investors may feel the need or desire to make major changes to their investment portfolio. Unfortunately, studies show investment related decisions based upon emotion tend to be the wrong decisions over the longer term. However, rather than simply doing nothing, there are steps investors can take in maintaining a more disciplined approach during tumultuous market conditions.
A key step is developing a focused, yet flexible plan regarding your long term objectives. Knowing and understanding your goals will be helpful in understanding how current market conditions impact your ability to reach your future goals. As important, reviewing your goals regularly is important to make sure there haven’t been major changes.
Next, be sure to know your tolerance for risk. One way to think about your risk tolerance is to look at historical performance. While we know past performance is not indicative of future results, looking at the historical performance of a hypothetical portfolio provides an indication of how a portfolio allocation might perform during times of stress while also showing how it performed over other times as well. As a rule of thumb, the longer your time horizon, the more risk you have the ability to accept. The question then becomes whether or not you feel comfortable taking on that amount of risk in the first place. Know that the timing of when you think about risk tolerance can have an impact on the outcome. For example, investors tend to have a higher risk tolerance when the markets are doing well while the opposite is also true.
A third step is to make sure you have a globally diversified and thoughtfully allocated investment portfolio. Maintaining a strategic allocation to various investments in a thoughtful manner is in fact how many institutions like pensions and endowments manage their money. Remember, being diversified doesn’t mean you aren’t taking risk, it just means you aren’t concentrating your risk. Some refer to diversification as “when something zigs, something else zags.” Instead, think about diversification as “not putting all of your eggs in one basket.” Interestingly, many pundits have recommended investors move out of their high quality fixed income allocation over the last several years as fears of rising interest rates were rampant. However, high quality fixed income often becomes a safe-haven asset during periods of market stress and can actually perform relatively well, adding overall value to a portfolio.
Another action investors can be implementing during difficult market periods is rebalancing. Rebalancing a portfolio is the act of moving the current portfolio allocation back to its target allocation, or at least closer to it. Over time and especially in periods of large market movements, an investor’s current allocation can move substantially away from their target. When an allocation moves away from the target, the amount of risk the investor is assuming also moves away from their target. One of the main purposes of rebalancing is to bring the current risk of the portfolio back to the target, more in line with the expected risk tolerance of the investor. Unfortunately, the actual process of rebalancing can seem counterintuitive to investors and therefore many shy away from it. This is because rebalancing forces investors to sell their winners, those securities that have done the best, and buy the losers, those securities that have done the worst. While it may seem counterintuitive on the surface, it is exactly what Investing 101 tells us: buy low and sell high. In the end, the act of rebalancing is more about making sure an investor’s appetite for risk is aligned with the actual amount of risk being taken.
Finally, another action investors can take during market downturns is loss harvesting. Some investors leave loss harvesting for year-end but in reality, there is no reason it shouldn’t be done throughout the year. Loss harvesting allows investors to realize their losses in order to offset a capital gain tax liability, reducing the future tax liability and increasing after-tax returns.
Market downturns can be stressful for any number of reasons. However, simply reacting to these market gyrations may not always provide the best outcome. Instead, having a plan and the discipline to stick with it should provide a better recipe for success.