Recent volatility in investment markets can be frightening when you’re saving for retirement, but one of the key lessons from history is that volatility is a normal and necessary part of investing.
Markets are made up of individuals making buying and selling decisions based largely on their view of the future. Given the future is uncertain, those individual views differ. From time to time, events that increase uncertainty about the future or lift the chance of a weaker economy can prompt sell-offs in the markets.
The daily market moves reported in the media can make things seem worse than they are.
A 1000 point move in the Dow Jones Industrial Average sounds big but it represents less than 4 per cent of the index in 2020. Contrast that with October 1987, when the Dow fell 500 points in a day—but it was a full 22 per cent of the index’s value.
Investors have certainly had to cope with severe volatility and uncertainty in recent years (and especially in 2020), from the worldwide spread of COVID-19, to US-China trade tensions, to fears of impending recession and worries about inflation taking off.
So how can investors remain focused and cope with market fluctuations?
The first step is to accept that volatility is normal and that it should be expected.
The second step is to have a financial plan. It does not need to be War and Peace just capture the essence of why you are investing in the first place, the goals you are hoping to achieve and a realistic stock take of where you are today.
The third step is to stay diversified, be disciplined to avoid impulsive decisions and stay focused on your long-term goals.
Sometimes, investors can be tempted to sell during downturns, getting out of the market to avoid the potential for further losses.
The problem with this strategy is it locks in losses and provides no exposure to the eventual recovery in prices.
Global markets experience eye-catching downturns on average about every two years. In fact since 1980 (and even not including recent market events sparked by COVID-19), global stock prices have fallen more than 10 per cent (called a ‘correction’) on 11 occasions. On eight occasions they fell more than 20 per cent, the very definition of a bear market.
Remaining in the market is a better strategy than selling.
Some investors might also be tempted to try to pick up a bargain during a downturn, buying stocks that have fallen heavily in the hope they will make outsized gains as sentiment recovers.
But the odds of picking the winners are small and the odds of timing market up days and down days are even slimmer, particularly as days of big moves (in either direction) tend to cluster together.
So remaining diversified is the superior strategy.
Diversification is a proven approach to managing investment risks, reducing the risk of damaging losses from the performance of a single asset or sector.
Not all markets perform badly at the same time and a diversified portfolio ensures that exposure to the worst performing markets is mitigated while delivering at least some exposure to the better performing markets.
Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.
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