Managing portfolios to successfully navigate the sort of volatility we have seen across global markets recently can be as much an emotional challenge as an intellectual one.
Making a clear distinction between short-term volatility and genuine risk is vital in resisting the emotional urges, such as panic, that can be the driver of ill-judged investment decision-making. Awareness of this issue can go some way to helping investors generate realistic returns over the long term, without exposing their portfolios to unnecessary risk.
Misunderstanding investment risk may be the biggest risk of all. Rather than indiscriminately avoiding all risk, investors should aim to add value by taking risks at the right price.
Risk ultimately comes down to one thing: the chance of losing money once it is time to close an investment. Volatility, on the other hand, is a measure of how much the price of an asset moves over time. Therefore, volatility should only be relevant to an individual investor’s time horizon. It is vital that long-term investors do not allow short-term turbulence to distract them from their fundamentals-based convictions.
But this may not be as easy as it sounds. Investors are human beings and can be victims of their own biases. What may seem logical in theory can be difficult to execute in practice. Sudden, sharp market movements can exert a strong emotional pull that can cloud rational judgement and compel investors to act illogically.
The best chance we can give ourselves of resisting these behavioural forces is to centre our approach on a framework based on observable facts about where asset valuations are today, versus where they have been in the past. We hope this creates rigour and discipline without being too anchored to a particular perspective. Therefore, investors should consider why valuations might have moved away from long-term averages.
Sometimes it is down to a shift in the fundamental economic facts, but more often it is because of a change in sentiment, which is less likely to be permanent. If these shifts in sentiment trigger bouts of volatility, it should be viewed as an opportunity, rather than a risk.
Tolerating such volatility may feel uncomfortable but it is important not to panic sell if the fundamental conditions underlying longer-term conviction about an asset are unchanged. Doing so may result in permanent capital loss for an investor. Furthermore, short-term volatility could provide compelling investment opportunities, as it can discount temporarily assets we already believe to be attractively priced.
Careful diversification can sometimes make volatility in one asset easier to tolerate. But, as we have seen recently, this will not always be the case. While diversification is the well-established cornerstone of managing investment risk, in phases where correlation patterns are highly changeable, a ‘set it and forget it’ approach to asset allocation will not suffice.
It is important to understand and challenge the correlation patterns among different asset classes and not simply rely on the associations drawn from past performance. In order to construct a truly diversified portfolio, it is paramount to maintain an objective view of asset valuations and to also take into account the effect human behaviour and investor psychology can have on asset pricing and their relative movements. Flexibility is therefore key.
