Investing through volatile markets

What you’ll learn:

• The positives and negatives of stock market volatility.
• The cost of being human.
• Why being diversified can limit the effect of volatility.

Reluctance tends to be the default position for many of us when thinking about investing, especially when we see periods of increased volatility in the markets - sudden movements in the markets. Investors become understandably hesitant, and are instead focused on the risk of economic conditions deteriorating and the effects this will have on returns. However, it’s not just about the risk of being in the market, investors also need to think about the risk of being out.

Two sides of the same coin

Stocks are the most visible asset class to many investors and the inherent volatility of stock markets has both positive and negative implications for investors. On the positive side, greater risk is associated with greater expected long-run returns. On the negative side, dramatic price movements coupled with mistiming investments can undermine even the most disciplined investor. Too often investors experience the negative traits and this leads them to miss out on the positives.

Volatility measures the size of price movements but not the direction. It inevitably brings significant downward moves but it can also bring significant price increases. Some of the best performing days over the last few decades have been in the wake of profound market turbulence. It's through these experiences we have learned that trying to time your investments can be a hazardous preoccupation for individual investors.

The cost of being human

Research on the 'investor behaviour penalty' shows the cost of market mistiming: the average return investors receive from stock funds is lower than the return they would have received with a simple buy and hold strategy. This isn’t because those funds are bad investments – it is because investors choose to move their money in and out frequently. Getting this even slightly wrong will reduce your return.

A Cass Business School study commissioned by Barclays estimates the investor behaviour penalty for the average UK investor at 1.2% per year. This is a conservative estimate relative to other research findings. For example, estimates for the US investors tend to be in the 3% to 7% range. The penalty tends to be larger in years with greater average volatility.

So, why does the average investor pay a penalty when attempting to time stock markets? Rather unsurprisingly we make decisions that feel emotionally comfortable at the time. Our intuitive emotional reactions tempt us to buy when economic conditions are booming and urge us to run for the hills when economic conditions look bleak. For those who stay invested the market turmoil takes a toll, depleting reserves of commitment and emotional resilience. The risk is that they sell out and undo years of investment by selling at a low point, thereby missing any recovery which may follow.

Where does this leave us?

Though holding cash after seeing some negative returns may feel secure and deliver immediate comfort, it leaves you both vulnerable to the possibility of foregone upside and, in recent times, the near certainty of your savings being eroded by inflation. The likelihood of achieving your longer-term goals may be compromised by holding cash.

In investing, market cycles are inevitable and these cycles will invariably deliver periods of anxiety inducing turbulence. If you can overcome the reluctance that volatile markets can bring there are ways to make investing more comfortable. Simply being diversified can limit the effect of volatility in your portfolio. It can also be useful to think about strategies for good investment discipline, like resisting the temptation to look at your portfolio too frequently. Although this is no doubt easier said than done there are ways that investors can overcome reluctance and achieve their long-term goals.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.