Our Blog May 04, 2017
Investors tend to sell and reinvest at the worst moments during periods of market stress and recovery. A consistent investment strategy may help curb this costly behavior.
Investors pursue any number of goals when they choose to invest, whether it’s accumulating wealth to fund their retirement, educating their kids or saving to buy a house. Smart portfolio choices can help investors achieve these things, but the impact of market losses can be pervasive and a threat to reaching their goals. A strategy designed to mitigate market volatility may lessen the likelihood that investors will act at inopportune times.
The liability of emotions
The impact of behavioral factors is often just as significant as market volatility itself. According to Morningstar, investors fall short of a fund’s returns because they tend to buy after it has gained steam and sell after it has lost value. This action causes them to miss out on the return stream. Investors in the U.S. equity category for the 10 years leading up to the end of 2015 lagged the average fund by 74 basis points (a basis point is 1/100th of a percent). They lagged by even more, 124 basis points, when it came to international equity funds.1 This isn’t a reflection in the skill of the portfolio managers, but rather it shows what happens when investors buy or sell at the wrong times and don’t consistently invest in a product.
A whole field of academic research — behavioral finance — has grown up to study this problem, and a number of specific issues have been identified. The problem goes beyond simply mistiming the market. Investors are susceptible to all sorts of other traps, including loss aversion, overconfidence, under- or overreaction to news stories and short-term market movements, uncritically copying the actions of others (herd behavior), a lack of proper diversification and being overly influenced by past performance when making decisions.
Volatility tends to amplify these investor emotions and behaviors, with more extreme performance triggering fear. At the beginning of the 10-year period, Morningstar-studied flows into equities were strong, but that money later left in 2008 and 2009 when investors sold near the bottom.
Learn to see opportunity
Markets have been going through a period of relatively low volatility since the financial crisis, in part because of interventionist policies by the central banks. But the Fed’s monetary policy looks set to change, and it stands to reason that, once the unprecedented stimulus is withdrawn, volatility will increase.
For many investors, that will be a negative signal, but it doesn’t have to be — volatility can also generate upside, but only for those who stay invested to participate in it. A strategy that avoids the worst of the stress in the market means investors stand a better chance of reaching their long-term financial goals.
Diversification done better
Enhanced diversification, in particular, can lead to more consistent returns, which help investors stay invested and avoid bad decisions.
This involves a move beyond the traditional diversification strategies that many people are used to, such as having a 60/40 portfolio split between equities and bonds. The traditional approach has served investors well in the past, but it can still leave them vulnerable as the equity portion makes up almost all of the risk in the portfolio.
Enhanced diversification involves a wider range of asset classes and focuses on how much risk each allocation contributes to the overall portfolios. A broad base of globally diversified asset classes should include global equity markets, interest-rate-sensitive assets such as government bonds, and inflation-sensitive assets like commodities, real estate investment trusts (REITs) and Treasury inflation-protected securities (TIPS). The important point is that no one component should have an oversized allocation to risk.
With future market volatility all but inevitable, an enhanced diversification strategy has the ability to deliver better outcomes so that investors can maintain progress toward their goals. Investors who recognize the benefits of this more consistent approach will have an easier time staying the course and avoiding emotion-driven pitfalls.
1 Source: Morningstar Investor Returns. Data as of 12/16.
Diversification does not assure a profit or protect against loss.