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Staying invested is not always plain sailing

05 March 2021

6 minute read

By Alexander Joshi, London UK, Behavioural Finance Specialist

In this edition of Market Perspectives, we have examined the downside and upside risks to the recovery. The key risk on investors’ minds should however be the risk to achieving their investment objectives. Staying invested may be the best way to do so.

A much anticipated base case of a strong vaccine-driven recovery this year could be affected by many risks, whether positive or negative. But as with every year in financial markets, events, anticipated or not, may get in the way.

No crystal balls in investing

When setting out the different risks to economic growth and market performance, more or less conviction may be attached to the likelihood of events occurring. Further precision is, however, extremely difficult. Many historical downturns have been hard to predict.

Precise probabilities and timings around events can give a false sense of confidence, which can lead to misplaced conviction that ultimately proves costly. Behaviourally, people also tend to overreact to small probability events, but underreact to medium and large probabilities.

When things don’t go according to plan

There will be times when unconsidered or low likelihood risks occur and raise market volatility while negatively affecting the value of held assets. The first rule is not to panic. Market events, particularly those that are unexpected or not in line with one’s prior beliefs, can be unsettling. Particularly when a strong conviction was placed on the prior beliefs.

Humans like control, and when it seems to be lost can take actions that help to regain this control. The problem is that what can help achieve this in the short term can come at the expense of the long term. For instance, actions taken that run contrary to maximising returns for a given level of risk over an agreed time horizon.

Remember the possible upside

When the word risk is used in investing, it is primarily used in relation to risks on the downside. But there are also upside risks to the economy and markets.

From the point of view of investor psychology, losses have been shown to have a larger impact on people than an equally-sized gain. Additionally, the desire to avoid losses can be stronger than the hope of making gains, so an investor may assign more weight than they should to negative scenarios and less to positive ones.

While the bounce in markets seen since March can give the impression that all positive news such as the authorities’ pandemic support measures must be factored in, and that any surprises must be to the downside, this doesn’t necessarily have to be the case. The next big productivity breakthrough, the engine of economic growth and future returns, may appear at any moment and is often impossible to predict.

But risk and uncertainty are uncomfortable

History tells us that getting and staying invested in the market is likely to be the best course of action for an investor seeking to reach their long-term goals, in the face of both downside and upside risks. For it is time in the market, and not market timing, which typically matters most for long-term returns.

However, knowing that there are positive as well as negative risks may not necessarily be reassuring to an investor thinking about getting invested, because inherent in the word risk is that there is uncertainty about the future.

Many believe that waiting for calmer times to get invested is a sensible approach in the face of uncertainty. The problem with this approach is being kept perennially waiting on the side-lines for a moment that does not materialise for a long time. In the meantime, markets may rise higher. Phasing in to the market may be an approach for these cautious investors.

Phasing in investments

For the investor who is nervous about getting invested against an uncertain backdrop, phasing in investments over time may be one way to increase comfort with getting invested. By drip feeding capital into the markets over many months or years, investors may be able to reduce the impact of short-term moves, which may improve the entry point.

We have spoken before about the difficulties of timing the market. In addition, the behavioural challenges of investing and the potential for cognitive biases and emotions to influence decisions can compound the difficulties with timing markets. In investing humility is a valuable trait; investors should accept they not always be able to invest at the optimal time, but should remember that over the course of their likely time horizon this won’t be what determines success.

Therefore, phased entry according to defined rules may be a sensible approach. A common approach is to split up a lump sum into equally-sized investments which are made at regular intervals over a period of time, for example monthly. Another is to use market index levels as entry points; this can be an effective way to enter, except if markets continue to rise and capital remains on the side-lines. The key point is to be specific in the plan, and maintain discipline and stick to it.

What risk should investors focus on?

We have outlined potential risks to economic growth and financial markets, on both the downside and upside. We have also considered phasing in to the markets as a way for investors to overcome jitters about short-term volatility.

But what is risk and how should investors think about risk in relation to their own portfolios? Risk is seen by many as a short-term concept – the volatility of an asset over a period of time. While short-term fluctuations in investments can be uncomfortable to weather, this is not the risk which is most material for investors.

For an in investor who is putting their capital to work in the markets to achieve particular long-term goals, the risk an investor should focus on is the risk of not reaching said goals.

Focus on the long term

Fluctuations in a portfolios value over the short term can troubling for investors. But this is not an adequate concept of risk for many investors. For investors putting their capital to work to achieve particular long-term objectives, risk should be defined as the probability of not meeting those goals.

This isn’t to say that events that affect an investors satisfaction with being invested should be dismissed; having an investment plan that one can stick to is as important as the plan itself. However, investors should remember that to maximise the returns from the capital put at risk in the markets, they should focus on the factors that maximise the chance of meeting their goals and not necessarily on having the smoothest ride.

Investing shouldn’t be all plain sailing, and fear of a bumpy ride should not be the barrier to getting invested. The biggest risk of all is not taking one.

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Market Perspectives March 2021

Encouraging hopes of a vaccine-driven recovery are keeping investors in good spirits.

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