Keeping calm in turbulent markets

• There could be a bumpy ride ahead for investors, but panic-selling is one of the worst things you can do in times of market volatility – having a long-term mind-set and avoiding rash decisions is key
• A carefully constructed portfolio with many different types of investments can reduce the impact of one area performing poorly
• Diversification is important for your portfolio. It should reflect your investment objectives in a range of scenarios – providing an “emotional buffer” from volatility that stops knee-jerk actions being taken that jeopardise long-term returns
• The key to navigating markets with a calm head is diversification, safe in the knowledge that objectives are secure.

In uncertain times and fast-changing markets, diversification may protect investors psychologically, helping them to reach their investment goals by avoiding taking rash, unwise actions.

The idea of diversification is to construct a portfolio designed to meet the requirements of an investor through a range of potential outcomes: it should be as forecast-free as possible.

The outlook for financial markets looks more positive than it did this time last year given the extraordinary strides made to fight coronavirus. However, while investors have reason to be optimistic, they should also appreciate that there are risks, related to the pandemic or not. The effect of accelerating inflation, even if transitory, is just one risk that may trigger more volatility later in the year and test investors’ nerves.

Unforeseen circumstances can throw off track even the best plans and bring behavioural proclivities that may trigger actions not in one’s best interest. Significant negative moves, such as the equity sell-off seen early in the pandemic, can spark selling even when an investor has sufficient liquidity.

Conversely, extreme exuberance, as witnessed this year in certain parts of the equity and cryptocurrency markets, can lead to investors being swept up in speculative bubbles. Even more so with social media bringing together retail investors to join the fray.

The building blocks for successful investing

The key building block for sustained successful investing is a robust investment process that allows well-diversified portfolios to be constructed for different market conditions.

But having the optimal portfolio alone is not enough without sticking to it over the market cycle. Investors also need a calm head and emotional comfort with being invested to stay the course and minimise biases in decision-making. This can prevent panic when times get tough and let you capitalise on opportunities.

Successful investors do not rely on sheer will to overcome biases; they use systems and tools to guide investment decision-making. Diversification is one such tool that, over and above the financial benefits covered in “A bird’s eye view on diversification”, can help bring calm and rational actions during the investment journey.

Behavioural diversification benefits

As humans we don’t like uncertainty and volatility. They can be uncomfortable to experience and the natural reaction may be to act to minimise them. As volatility increases, so too may the likelihood of paper losses. This, in turn, is likely to decrease holding periods and increase trading behaviour, both of which are correlated with decreased returns.

Actions that may give the investor short-term comfort, such as from selling out of the market to cap the downside, can impact performance over the long term. Reducing holdings during a spike in volatility can lead to missing out on a recovery and growth while the investor waits to get back into the market.

Diversification can provide an “emotional buffer”. By protecting a portfolio from the effects of volatility and the risk to investment success of holding relatively few securities, a diversified portfolio may also insulate the investor from being caught up in the emotions they induce. This can help to navigate markets, with a calm head and assurance that financial objectives are secure, even in large market disruptions.

It is not just in response to crises that diversification is useful, but also to counteract subtle behavioural biases that may drag on returns if left unchecked. For example, the home bias – a preference for assets which are familiar (be that geographically, by company, sector, asset class) – can overly concentrate portfolios in the hands of a few stocks.

Creating the foundations to grow your wealth

As we head into the second half of the year, good investment hygiene may involve taking stock of existing investments to ensure you have the right foundations to protect and grow wealth. Do you have a specific plan in place to grow your wealth? Are you following a robust investment process that has led to a diversified portfolio? Are you thinking about your investments in the context of your goals?

Holding a diversified portfolio can let the investor turn down the noise of market commentary, given that some headlines are unlikely to affect the portfolio materially. Remember that the market isn’t a single entity that moves as one.

With this calm, investors can look at events and actions in the context of their goals and ask themselves how they are likely to affect their ability to reach these long-term goals.

By helping to avoid the temptation to overreact in response to short-term market moves, a diversified portfolio provides a solid foundation for protecting and growing wealth. Such a strategy may allow you to focus on reaching your investment objectives.