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Market volatility is unnerving, for even the savviest of investors. In this article we provide you with some key tips on how to manage – and potentially benefit from – market volatility.
The notion of investing without volatility is as illusory as a car without an engine. Like it or not, the two concepts invariably go hand-in-hand, but does that mean you should avoid volatility – and investing – altogether? Market uncertainty can naturally cause panic and lead to poor investment decisions. But by recognizing short-term market uncertainty for what it is, you can help ensure that it doesn't derail your long-term financial plan. Here are five tried and tested principles that can help you gain needed perspective:
- Billionaire investor Warren Buffett
Investors generally feel a financial loss about two and a half times more than a gain of the same magnitude.* Understandably, many of us experience a roller coaster of emotions when investing (as the diagram below illustrates), which can translate into poor buy and sell decisions. Being aware of these emotions during times of volatility will help you stay on the straight and narrow and away from the cycle of market emotions.
Why shouldn't you automatically trim your investments when market uncertainty sets in? Because trying to time the ups and downs of the market is a bit like rolling the dice and sitting on the sidelines can cost you.
As the illustration below shows, over a 10-year period if you're not invested for only a small fraction of days when the market is performing at its peak, you can substantially erode your savings. Staying invested – sometimes referred to as the 'grin and bear it' approach – can potentially translate into a better outcome.
Risk can be a loaded term when it comes to investing – and is often misunderstood. For example, volatility is often seen as synonymous with risk, but in fact volatility simply measures how much a return fluctuates.
While investors may fixate on these fluctuations, the permanent loss of capital should be of greater concern. Often, investors believe that reducing exposure to securities that are perceived as 'risky' helps to lower risk, but some investors ignore other risks altogether, such as longevity risk – the risk that they'll outlive their retirement savings.
Whether we like it or not, investing and risk are a package deal – you can't have one without the other. The key to long-term investment success is to manage your exposure to risk by using time and diversification to your advantage. While the performance of any portfolio can swing significantly each year, a balanced portfolio has historically resulted in fewer negative returns when compared to an all equity portfolio over the long term. The charts below illustrate this concept.
Often equated to not putting all your eggs in one basket, diversification is a technique that mixes different types of investments in a portfolio to help smooth out returns over time.
By including investments that have different reactions to economic trends – or have a negative correlation to one another – as one type of security falls the other should rise, which can help to offset the negative effects. As the chart below illustrates, a diversified portfolio of different asset classes provides the opportunity to participate in potential gains of each year's top winner while aiming to lessen the negative impact of those at the bottom.
Short-term ups and downs can cause you to lose sight of the big picture, which is why it is so important to seek advice and develop a financial plan. Research on the value of advice has shown that investors who work with a financial advisor not only save at a higher rate than non-advised investors, but they also have a greater feeling of confidence about their financial future than those who don't work with an advisor.
If you have taken the time to determine what your financial goals are and have a financial plan to help you reach those goals, this can go a long way to keeping you on track and remind you why you're investing in the first place, whether it's for retirement, your child's education or some other goal important to you.
Understanding your initial reactions to market ups and downs can help you make better investment choices and view your portfolio more objectively.