Market volatility - stay invested or move to cash

Periods of market volatility can be unsettling. What goes through your mind when you are invested and the markets have taken a bit of a tumble? If it bothers you, I assure you, this is normal. According to behavioural finance, it is how we are wired - the pain we derive from market losses impacts us twice as much as the pleasure we feel from market gains. Stock markets go up and down- we all know this. Market moves are affected by real emotions, investors have thoughts and biases (called reflexivity ) which affects consumer confidence, financial expectations and eventually market declines and rises. From about October, 2011, the S&P 500 index went nearly four years without experiencing even a 10% decline (on a closing basis), the longest such streak since 2007 and the third longest since 1950. From August, 2015 this has changed and we can connect the dots by reading the headlines about China, oil and the fear of a US or global recession. How does one cope with all this volatility?

First, what is volatility?

Volatility is a statistical measure of the tendency of a market or security to rise or fall sharply within a short period of time.- Investopedia

To further illustrate, the stock prices of small, newer companies such as those listed on AIM (AIM is the London Stock Exchange’s international market for smaller growing companies) tend to rise and fall more sharply over short periods of time than the prices of well established, blue-chip companies; hence, these are described as more volatile.

Your head and heart

Since we human beings are emotional beings, it helps to integrate both the head and heart in a balanced way- the logical brain helps us to be rational; it is also useful to listen & understand our emotions as they give us great information, sometimes straight to our gut & clues about what we need (reassurance/information).

Let's go through some scenarios. For the purpose of this blog, I am sticking with two simple ones however there are clearly a wide range of possibilities.

Move to cash?

This may eliminate some worry and fear. Yet, it is a well know fact that it is extremely hard to time exits (and entries). What if the markets rebound soon after you move to cash and you miss out on the upside? Plus, surely when you invested, you accepted that it would be for the long term. Part of the deal of being rewarded as an investor is accepting the volatility that comes with investing. And then there are the stats like: if an investor stayed fully invested in the S&P 500 from 1993 to 2013, they would've had a 9.2% annualised return.However, if trading resulted in them missing just the ten best days during that same period, then those annualised returns would collapse to 5.4% (Taken from the 2014 JP Morgan 2014 Guide to Retirement).

Stay invested?

The market has rewarded investors historically with a premium over cash and bonds because it requires you to stay put during times of volatility. Without volatility, we would have no reason to expect long-term gains. Unfortunately, without the higher growth that comes from investing, it would be next to impossible to meet long term financial goals. I know some of mine including having greater financial freedom; I would like to be a millionaire ISA holder someday (hey, John Lee has done it...and he is my inspiration!) and embracing volatility  will have to be part of my plan.

The investor’s chief problem—even his worst enemy—is likely to be himself - Benjamin Graham, Investor/teacher

Some strategies that may be helpful

So, I can share with you what I believe may be helpful to counteract some of these fears:

  1. Check that you have a diversified portfolio with an asset allocation allocated according to your ability (time horizon) and willingness (intestinal fortitude) to take risk. If this is not the case, there may, indeed, be grounds for change in which case, act swiftly. If you work with a financial adviser and it isn't time yet for your annual/half yearly review with your financial adviser, initiate it.

  2. Arm yourself with an understanding of some of your investor biases. Here is a comprehensive list of behavioural biases I found - quite an amusing read.

  3. Have some kind of practice that gets you well acquainted with your emotions. For me, it is Non violent communication and meditation...it could be any kind of practice that gets you feeling more connected to yourself and mastering those difficult emotions.

  4. Remind yourself of the long term nature of investing (as many times as needed).

  5. If you really cannot stomach the volatility, it may be best to accept a portfolio with much lower returns and lower risk.

I end with a quote by Benjamin Graham, author of 'The Intelligent Investor'

Successful investing professionals are disciplined and consistent and they think a great deal about what they do and how they do it- Benjamin Graham

And my closing comment- a decision to make changes to your portfolio is an important one, involving careful consideration with inputs from both the heart and mind.