For most investors, volatility isn’t fun. Investor sentiment has slumped to notably pessimistic levels, so it’s no wonder questions are being asked whether it’s time to exit the market and hold on to excess cash until the storm passes.
The short answer: not yet. In fact, for most long-term investors, it’s probably the time to stay invested or get in.
Don't put all your eggs in one basket, the adage goes. This is the golden rule of investing for the long run.
The idea is that a diversified portfolio can help mitigate losses in the event of a market downturn.
In this year’s sell-off, both stocks and bonds have seen a decline but even a basic diversified portfolio has offered protection.
At their worst point in January, global stocks were down 8 per cent while the diversified portfolio dipped by only 6 per cent.
To be clear, a diverse portfolio cannot keep up with one consisting only of equities, when the stock market is rising. Instead, this concept is all about mitigating the downside.
By helping investors avoid the full brunt of market downturns, diversification has historically helped a portfolio’s value recover sooner and smooth out the ride along the way.
Dalbar, a financial services research company, analysed how emotions affect investment decisions by studying the timing of mutual fund flows.
Based on that analysis, Dalbar estimated the return achieved by the average investor over a 20-year period. It found that most investors are bad at timing the market but still attempt to do it.
Amid strong index returns over time, the average investor has underperformed a basic, indexed 60/40 portfolio by 3.5 per cent annualised.
For instance, on a $100,000 investment from the year 2001 until the end of 2020, that adds up to about $170,000 worth of missed gains.
Diversification can help reduce the pain investors experience during a market correction. It may also help avoid the temptation to sell out of investments when markets are volatile.
Timing the market is tough
Many people believe they can time the market better than the average investor. However, it’s crucial to consider the risks of doing this.
The next time market volatility makes you second-guess your long-term investment strategy, have a good think before you exit the market. There could be a 70 per cent chance that you may miss capitalising on one of the best days.
There’s always something to be worried about
In 2020, investor worries focused on Covid-19. Last year, they were worried about new variants of the coronavirus, China’s property market turmoil and regulatory action. Today, they are concerned about inflation, central bank policy tightening and the Russia-Ukraine conflict. What’s next?
Do not dismiss prevailing risks; instead remember that markets tend to right themselves as these risks pass.
Volatile times are when active management and thoughtful portfolio construction can earn their keep by adjusting exposures to better weather the bumps.
The bottom line
Diversification, time in the market and a steady head can help investors achieve their long-term financial goals by avoiding the pitfalls of emotionally driven, badly timed mistakes.
When times get tough in markets and make you feel nervous, remember the lessons from tried-and-tested investing principles.
Steven Rees is head of investments for the Middle East and North Africa at JP Morgan Private Bank