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Personal Capital Investor’s Guide to Volatile Markets

October 19, 2018 | Personal Capital

Life is full of uncertainties. We protect our families with life insurance and our cars and homes with auto and homeowner policies. But how do we protect our financial futures?

Even during times of relative stability in the financial markets, having a long-term financial plan in place that is built to weather the unknowns is a smart move to make. The market is, after all, rarely driven by just one factor – that’s why it’s so hard to time the ups and downs. Investors with a strategic plan can feel more confident about their finances and don’t have to worry about outguessing factors beyond their control.

There’s a saying: “By failing to prepare, you are preparing to fail.” The Personal Capital Investor’s Guide to Volatile Markets is designed to help you prepare for – or react to – what the market might throw at you. Like many things in life, luck and timing play a big role in your financial success. These factors may be beyond your control, but regardless of how they play out, it’s up to you to exercise control where you can. With a long-term plan and clear goals in place, we believe that you can navigate your way through the up and down times to achieve your financial goals.

We will cover 6 costly mistakes that investors can often experience in a volatile market, including:

  • Emotional decision-making
  • Recency bias
  • Failure to define risk
  • Failure to understand investment risk
  • Trying to time the market
  • Insufficient diversification
  • …and more!

Download the Guide as PDF

The Impact of Behavioral Finance

Before you get started on a long-term financial plan, it can be helpful to understand some of the underlying components that can make a plan successful regardless of where the market goes.

While this is by no means a comprehensive list, it’s important to recognize these variables and the impact they can have on you and your investments.

EMOTIONS

Staying focused on a long-term plan with clear goals is the best way to navigate what can sometimes be an emotional roller coaster. Emotions are neither good nor bad; however, they cannot be avoided, and are often heightened when money and life savings come into play. It’s natural to have an emotional reaction to money and volatility, but making decisions based on can negatively impact an investor’s financial future. Markets can be volatile over short or long periods of time. Although we don’t know for sure what the next day will bring, how we react to volatility is what we as investors can control.

Unfortunately, our brains are wired to want to chase results and make emotional decisions. We know we are supposed to buy low and sell high, but we’d rather buy into the hot investment (buying high) and then sell it when it doesn’t work out (selling low). That’s why the average investor will consistently underperform a basic market index.

PERSONAL CAPITAL STRATEGY: MANAGE YOUR EMOTIONS

A great way to better manage emotional reactions when it comes to your finances is to know where you’re going. The Personal Capital Retirement Planner will do just that by helping keep track of your holistic financial picture. Just as importantly, it will help keep the focus on the long-term path to your financial goals, which leads to better decision-making. Long-term-focused or not, it is natural to be emotional in down market periods, but panic selling is rarely a good idea. The good news is, if you feel like you overestimated your risk tolerance or need a more holistic investment approach, right now can be a great time to adjust to the right properly diversified strategy. To learn more, speak to a financial professional.

RECENCY BIAS

The problem with investing starts with our natural inclination to want to own what has done well recently.

It makes for a good story at the cocktail party to say we made a big bet on the “latest and greatest” investment. This effect is common enough that it has its own name: recency bias. Recency bias is the tendency to think that trends and patterns in the recent past will continue in the future, which then impacts certain conclusions, decisions or behaviors.

According to a BlackRock survey of retirement plan participants, 66% of surveyed workers believe that over the next decade, returns on their savings will continue to be in line with what they have experienced in the past, while 17% believe they will experience even higher returns. This shows how this type of bias can be particularly dangerous during periods of rising markets because it can grow stronger as the market reaches higher peaks. For example, a lengthy bull market can lull us into a false sense of security, which can translate into trouble – how do you think asset bubbles are created?

Recency bias works the opposite way, too, when you experience negative events. In 2008, the economy was teetering on the precipice and the stock market crashed. Many investors quickly determined that these negative events would continue, and they liquidated their investment portfolios. When the financial markets rebounded, many of those same investors realized their error and jumped back into the markets. Unfortunately, they locked in their losses and bought back in after much of the recovery had already happened. Recency bias cost those investors a lot.

PERSONAL CAPITAL STRATEGY: PREVENT RECENCY BIAS

Since recency bias is a natural human tendency, how can you avoid being tricked by your own brain? Here are some tips to keep this bias in check:

  • Seek an accurate picture of your financial assets and liabilities
  • Establish achievable financial goals aimed at satisfying your long-term needs
  • Identify and prioritize your risk tolerance levels and stick to your long-term plan vs. short-term trends
  • Determine how much time you have to save to reach your goals
  • Find appropriate professional assistance to help keep you on track

Keeping these tips in mind means you may minimize your impulse-based decisions, which is a good start to staying focused on your long-term goals.

RISK TOLERANCE & RISK AVERSION

Risk tolerance is critical to constructing an appropriate portfolio for each individual, but the industry in general does a poor job of using it.

The first problem is a lack of standard definitions. Being “aggressive” or “moderate” or an “eight out of 10” can mean very different things to different people. A second major problem associated with risk tolerance is inappropriate application of it. Your willingness to take risk is only part of the equation. Your objectives for taking risk are just as important as your stomach for it.

The key is finding the right combination of need, desire, ability, and willingness to take risk. The step after identifying your risk tolerance is designing a portfolio that properly utilizes it – and that you will stick with. A mismatch between stated risk tolerance and portfolio design can be quite common among investors.

It’s good to keep in mind that higher returns come with higher risk, but on the other hand, being too conservative over time can be just as big of a mistake as taking too much risk.

PERSONAL CAPITAL STRATEGY: DEFINING RISK TOLERANCE

In designing financial strategies for our clients, we’ve been careful to define risk levels using both risk tolerance and objectives. Using standard language helps us stay consistent. Here are some helpful ways to define various levels of risk tolerance:

  • Highest Safety – Market volatility makes very uncomfortable. Safety is a much higher priority than growth for me, and I do not expect growth meaningfully above inflation.
  • Conservative – I am able to accept some volatility, but have difficulty stomaching meaningful fluctuations in account values. I expect long-term growth somewhat above inflation, but am willing to sacrifice up to half of my potential long-term return in exchange for less volatility.
  • Moderate – I am comfortable with moderate volatility consistent with a diversified portfolio which includes a significant allocation to stocks. I prefer to sacrifice some long-term return in order to reduce risk.
  • Aggressive – My primary objective is to achieve growth, and I am comfortable with typical stock market volatility. Still, I am willing to trade a small amount of growth potential to reduce risk.
  • Highest Growth – I am willing to take a high degree of risk in pursuit of higher returns, and am very comfortable with the volatility of a 100% stock portfolio.

Speak to a financial advisor to learn more.

TYPES OF INVESTMENT RISK

While risk tolerance may refer to the appetite you have for any given risks, it’s good to also familiarize yourself with different types of investment-related risks.

Some of these include individual risks associated with your specific circumstances and environmental risks associated with general events. Some examples of these include:

Personal risk
Job loss, illness and other life events are examples of risks that are different for each person and can change unexpectedly at any time.
Market risk
How much will the price of your investments move up or down with general market trends?
Timing risk
How much will the price of your investment move up or down after you have invested?
Interest-rate risk
Changes in interest rates can create fluctuations in the value of investments, particularly bonds.
Inflation risk
If you invest too conservatively, your returns might not keep up with inflation, which means your nest egg’s value can erode over time.
Geopolitical risk
All types of world events, including war, political upheaval and unfavorable economic policies, create additional investment risks.

TIMING THE MARKET: A MYTH

Market timing and stock picking are like going to Las Vegas.

You might win, but most likely, you will lose. If you go every year, it is nearly guaranteed you will end up losing overall. The difference is you are betting big chunks of your net worth. (And you’re not even getting free drinks.)

The trouble with market timing is that in order to win, you must correctly predict market cycles. First, you must predict when to sell an asset class. Now? Next week? The end of the year? You don’t have a crystal ball, so you can’t possibly know the correct answer.

Even if you do correctly guess when to sell, you’re not free from the market-timing trap. In fact, you’re just halfway there. Now, you must figure out when to get back in. If the market drops 600 points in a day, will you dive back in? Will you wait for a full week of falling returns or a terrible month of returns? What if you wait for a bad month, buy back in and the market continues to fall? Will you bail again?

And if you are lucky enough to have successfully timed both sides of the market, did you really make any money? That depends on the size of your gains and the cost of trading in and out of the market. If your gains are relatively modest, trading costs may eat up most of your profits.

Example: Time in the Market vs. Timing the Market

Diversification as a Safeguard

As we’ve mentioned, if you’re thinking about the long haul, predicting the market is never effective.

What is one of the strongest safeguards against market volatility? One word: diversification. We believe that a properly diversified portfolio prepares you for whatever may happen. After all, who knows what the future will bring?

WHAT IS DIVERSIFICATION?

We know we need to diversify, but what does that really mean? It means owning a variety of asset classes, including those that are out of favor. It means buying some more of these asset classes when they don’t do well. Sometimes today’s “must-have” is tomorrow’s “has-been.”

In other words, a properly diversified portfolio has assets that have a negative correlation – when one part of the portfolio goes up another tends to go down. If everything in your portfolio is going up, you’re not diversified. How else can you buy low and sell high if nothing’s down when something else is up? It’s no fun watching parts of your portfolio going down, but having the discipline to rebalance to the proper diversification with your long-term goals in mind will help drive long-term results.

HOW TO DIVERSIFY

Diversification is achieved by owning multiple asset classes and securities with a positive expected return and low or negative correlations. Simply put: their values tend to move in opposite directions relative to one another in response to market events. It is also important to diversify at the sub-asset-class level.

Size, style, sector, and industry are important factors. It’s generally good to aim for a well-balanced mix within each. Diversification is also important within bond holdings: the issuer, duration, and credit quality are key factors. Inflation-protected bonds provide important diversification, helping shield returns against rising prices.

Once constructed, a properly diversified portfolio must be maintained. Periodic rebalancing ensures that the portfolio remains consistent with its original goals. It can also boost returns by reducing volatility resulting from sector and style bubbles.

Prep for the Future: Steps to Take Now

Market volatility can be a roller coaster – it can scare the best of us.

But detaching these emotions from investment decisions is one of the hardest psychological biases to overcome. What can you do to better prepare for the future and handle volatility during a financially and emotionally turbulent time? A few tips can help protect your portfolio from one of its biggest enemies: your emotions.

1. Consider hiring an advisor
If you have a tough time separating emotion from your decision-making, remove the need to make decisions altogether. This is one of the biggest benefits of having your investments professionally managed. An advisor (preferably a fee-based RIA) can objectively evaluate your financial goals and recommend a long-term strategy best suited to getting you there. And if you still get scared from time to time, you have a voice of reason just a phone call away.
2. Periodically rebalance
Disciplined rebalancing is one of the most important components of a successful long-term strategy. It ensures you’re constantly buying low and selling high. Again, this is something an advisor can help with. It can be emotionally difficult to sell some of your best performers and buy your worst performers, but over time it works. And market volatility can create some valuable rebalancing opportunities.
3. Stick to your long-term plan
It’s okay to be opportunistic in a down market – you can use it as a rebalancing opportunity, or even a chance to pare back concentrated positions. But you should avoid drastic changes to your long-term strategic portfolio allocation (e.g., selling everything and sitting in cash). A proper allocation should accommodate both down and up markets. For successful long-term financial planning, it is critical to understand what you’ve got, how much you make, what you owe, how you spend, and how you are investing for the future. If you have a solid foundation, then a thorough assessment of your position will make that abundantly clear. If you face serious challenges, clearly understanding them will empower you to make adjustments and significantly improve your situation and financial future.
4. Know your asset allocation
Asset allocation refers to your portfolio’s relative exposure to the major types of liquid investments. In other words, how much of your money do you put in stocks, bonds, cash, and alternatives? Successful asset allocation strategy balances your need, ability, and willingness to take risk. It should be based on your expected cash flows and be designed to maximize the odds of achieving your retirement spending goals. It is widely accepted that asset allocation is probably the most important factor in successful investing.
5. Ensure proper diversification
At the end of the day, no matter how aggressive you want to be, putting all your eggs into the proverbial basket is too risky. When we see markets go down, the most important component is recovery. How quickly can you recover from that type of market shift? If you have even a couple components in your portfolio that are going up while the majority goes down, then you’re shaving off time between recovery and growth. Owning things that may not look as attractive in today’s market could become the stepping-stone toward actual growth in future markets.

Questions to Ask Yourself

When it comes to weathering market volatility, one important first step is being familiar with what your portfolio actually looks like.

So how do you know if you’re where you should be in terms of your portfolio? Here are some good questions you should ask yourself – or your advisor – to see if your investments can weather the storm, today and in the future.

1. At what stage of life am I?
Much of your financial strategy is predicated on where you are in life and where you want to be in the future. Are you married? Do you have kids? Is paying for your kids’ college or perhaps retiring at a certain age one of your long-term goals? If so, you may want to consider how much risk you can afford to take, and how much volatility you can withstand while still reaching those goals.
2. How much time do I have to dedicate to my financial plan?
There’s no doubt that successful financial planning takes ongoing effort, time, and energy. Think about your busy life, and evaluate how much effort you want to put into this. Can you do the legwork to research 80-plus stocks, and do you have the resources and the knowledge to do so?
3. What is my target asset allocation, and is my portfolio in line?
An asset allocation is a portfolio’s percentage mix of stocks, bonds, alternatives, and cash – essentially all of the liquid asset classes. The precise mix should be tailored to your specific financial situation, risk tolerance and goals. It is probably the most important driver of long-term total returns, so it’s a decision you want to get right.
4. Does my portfolio contain any concentration risks?
Concentration risks are large overweights to any one area of the market. These can include one or more economic sectors, sizes, styles, or individual stocks, among other things. They can be intentional market bets or occur unintentionally from owning cap-weighted index funds or failing to rebalance back to target weights over time. Regardless, they can present significant risk to portfolio returns, particularly if they’re in the form of single stock positions.
5. How do I deal with a rapidly falling market?
There is a considerable amount of factors at play when investors are confronted with a volatile market. From internal to external forces, your reaction to market volatility can drastically impact your whole life. So, ask yourself: how do you know when to get out of the market? And how do you know when to get back in – and how do you determine what to get back into? What is your previous track record of going to cash? And while you may think you have a solid plan in place, do you have any previous examples of executing on this?

Disclaimer: This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data's currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

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