The consequences of de-risking

All data referenced in this article is sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• Market volatility in April was extreme to say the least. The S&P 500 had its largest daily gain and second and third biggest one-day falls in the month
• At such times, the urge to de-risk a portfolio can be strong. For long-term investors focused on protecting wealth, this approach comes with a health warning
• Investors that remained in a hypothetical medium-risk multi-asset portfolio when COVID-19 rocked the S&P 500 in 2020, would have chalked up gains over around 30% more than those that de-risked into cash
• The rest of 2025 could be as uncertain for markets and uncomfortable for investors as the first four months have been. In such times, the value of clear thinking, patience and perspective comes into its own.  

As the US launches a trade war with the world along with a barrage of policy shifts, markets have been turbulent in April. Understandably, this is an unsettling time for many investors.  

To call the world uncertain presently would be an understatement. Volatility is part and parcel of the investment journey. However, the wild swings seen in many asset prices in the past month is far from normal. The S&P 500 experienced its second and third (-6.0% and -4.8% respectively) largest one-day falls last month, as well as the single largest move (+9.5%).  

Seeking safety 

Volatility and uncertainty trigger a fundamental human instinct: the urge to seek safety.  

When volatility rises and the prospect of losses enters the financial market discourse, some investors’ first instinct is to reduce risk their in their portfolios. De-risking can take the form of selling equity holdings and buying more bonds, cutting exposure to high-yield debt while upping government bonds, or even cashing out of the market entirely.  

If an investor’s primary goal is to protect wealth, this instinct can feel like a common sense, responsible approach. This is especially true if they are also involved in running a business that is directly impacted by the key issues affecting financial markets.  

But, for some, their emotions and behavioural biases might drive how they invest, with costly consequences.   

Bear market psychology 

Bear markets (occurring when markets have fallen by at least 20% from their last peak) often magnify behavioural biases. Risks feel bigger. Worst-case scenarios dominate attention. But their salience can distort perceptions of probabilities. That’s when investors may react to an environment that may be short-lived. 

What are the key biases that investors should watch out for to check that their proposed actions are actually a rational response to market conditions? 

• Loss aversion – Losses feel more painful than equivalent gains feel rewarding. When markets fall, the fear of further losses induces emotional actions
• Myopic risk perception – Volatility creates a heightened sense of risk, which is exacerbated by shortening the time horizon which investors focus on
• Recency bias – Recent falls are extrapolated, with investors assuming the recent trend will continue, forgetting long-term trends
• Overconfidence in timing – Investors confident that they will be able to re-enter the market at a better entry point, despite the difficulties in successful market timing
• Herding – Investors can feel psychological pressure to do the same as other investors are apparently doing, for fear of being left ‘holding the bag’. 

The long-term implications 

Moving down a risk profile or selling out might feel safe and prudent, and provides a buffer against further drawdowns. But whilst volatility can have an emotional cost, comfort also has one too. Allocating  assets more conservatively locks in a lower long-term returns. 

This year’s market drawdowns have some parallels with the COVID-19 market crash in 2020. Then, uncertainty surged in the face of an unknown threat, and the S&P 500 fell 30% from its all-time high in little over a month (before surging to close the year up by 16%).  

The chart below shows the impact on portfolio performance for an investor that reduced the risk profile in a hypothetical medium-risk multi-asset class portfolio in March 2020. Those that hadn’t de-risked their portfolio would have seen their portfolio grow by around 30% as much as those that sold out and held cash over the last five years.  

The compound annual growth rates since 2020 for investors de-risking from a medium risk multi-asset portfolio into a low-risk one or into cash are 7.7%, 5.2% and 1.1% respectively.

The implications of de-risking investments

The S&P 500 sold off in early 2020 following news of the COVID-19 pandemic. The chart looks at the effect on investors that decided to de-risk a hypothetical medium-risk multi-asset portfolio at this time. In other words, adopting a more defensive asset allocation (reducing developed market equity exposure from 44% to 31% and increasing government bonds from 31% to 42%). Another line shows the impact of selling out completely into cash

Avoid making the wrong move 

Significant downturns can be followed by sharp recoveries. Many of the best days of market performance typically come soon after the worst.  

Changing allocation in practise requires selling risk assets, which potentially means crystalising losses, and then re-entering at higher levels.  

Reluctance begets more reluctance which can also lead to investors underweight risk assets over the longer term. 

Alternative ways to manage risk 

In challenging market environments investors can feel like they need to make a binary choice; stay in or exit the market. The reality is that there is much that there is much that can be done to protect the long-term potential of their portfolio, while resting easier at night. More gradual rebalancing, or hedging, may be a more appropriate way to do so. 

This points to the value of a core-satellite approach, allowing investors to stay true to their long-term strategy with a core portfolio, whilst using a smaller satellite portfolio for making tactical shifts to capitalise on relative-value opportunities and mitigate risks. This approach emphasises making tweaks rather than drastic changes to portfolio allocations. 

There are always opportunities 

Whilst investors may be seeking ways to reduce risk, it is also important to recognise the importance of taking risk, because it is precisely for taking risk that investors earn returns.  

Long-term investors should also keep in mind their goals, and recognise that such market environments –  when prices fall and sentiment is as negative as it is – can also present buying opportunities. For one, market-neutral strategies might offer ways for investors to take advantage of the volatility, irrespective of the directionality of the market. 

One constant in a sea of change 

If the start to 2025 has been very volatile in markets and ever-changing US policy, there is every chance that the rest of the year could see more of the same. Both in financial markets but also in narratives.  

Calling the bottom in such an uncertain environment, where so much stems on the actions of one individual, is simply impossible. 

The reality is that no one truly knows what comes next. Forecasts will continue to shift. But what doesn’t change for investors is the value of clear thinking, patience and perspective.