If you’ve watched television or read a newspaper lately, you’ve seen the headlines: Stock market volatility has everyone on the lookout, or Stop this stock market ride. I want to get off!
Stocks have been on a roller-coaster in 2018, first surging in January on the heels of tax reform, then plummeting in February on concerns over rising inflation and interest rates. After a brief recovery, the market was challenged once again — this time by trade policy.
It’s enough to give investors whiplash.
These recent market gyrations also have investors wondering whether the return of volatility is a short-term hiccup or the new normal, and whether they should make major changes to their portfolios.
Volatility is tough to stomach, but investors should keep market movements in perspective. Through January, the S&P 500 SPX, +0.11 percent had posted 15 straight months of positive returns with little volatility. That’s unprecedented, and it lulled many investors into complacency. The “new” volatility we’re experiencing is actually normal in terms of historical market behavior. That’s why in times like this, it’s important not to let your emotions dictate your actions.
Don’t get caught in the ‘return gap’
Experienced investors understand that market corrections are a natural part of the investment landscape, and that they should look beyond the headlines for guidance. Yet humans are wired to desire more of what gives us pleasure and less of what gives us pain. These crosscurrents often clash when we invest.
Certain behaviors — such as selling stocks during a market downturn — create “return gaps.” A return gap reflects the difference between the average return for a fund or index and what the average investor earned within the same investment.
That gap exists because that average investor, concerned about market corrections, often will pull out of the market, missing the recovery period and the ability to increase their return.
Even after crafting a personalized investment approach and financial plan, investors can react in the moment or adhere to long-held beliefs that may undermine returns. Those factors, called behavioral biases, are subconscious tendencies that drive an otherwise rational person to act irrationally.
Here are several common behavioral biases that can affect investment decisions:
- Belief in being ‘above average’: Overconfidence leads investors to believe that they’re a stock picking genius when an investment performs well. But when that investment sinks, those investors blame the drop on “the market” rather than admitting that they are below-average at stock picking.
- Following the crowd: When the larger group does something, like buy a “hot” stock (think internet stocks in the late 1990s), or sell in a panic when the market drops, others follow suit. Avoiding the herd is one of the best things you can do for your own finances.
- The pain avoiders: People feel the pain of a loss about twice as much as they feel the pleasure of the same-sized gain. In other words, these investors prefer not to lose $100 rather than to gain $100. This aversion to loss causes investors to make poor decisions during market downturns.
- Selective confirmation: Some investors seek information that confirms their idea about an investment rather while avoiding information that contradicts it. This confirmation bias can result in faulty decision-making because one-sided information leaves investors with an incomplete picture of the situation.
- Hindsight is always 20/20: Hindsight bias causes investors to believe, after the fact, that an event was predictable and completely obvious, whereas the event could not have been reasonably predicted.
Most individuals have these biases, and the first step is to better understand them. The next step is to manage them, which you can do through discussions with your financial adviser about market expectations and periodic reviews of your goals, time horizon and risk tolerance. Your financial adviser can stress test your portfolio against various market conditions to help you see the impact of market volatility.
Take action to help protect your portfolio
Issues like the state of the market — whether a bull market or bear market — are not in the investor’s control. However, investors do have some opportunities to manage downside risk.
These three time-proven strategies can help keep you on track regardless of market movements:
1. Review your risk tolerance
You may find that your ability to handle market swings varies over time. That’s natural, and it’s important to acknowledge your change in attitude so you can adjust your plan if needed. At the same time, don’t overdo it. Keep in mind that you will likely live in retirement for 25 years and that you’ll need some growth-oriented investments in your portfolio to achieve your retirement planning goals.
2. Diversify your holdings
You can help reduce the impact of volatility on your portfolio by owning a mix of domestic and international stocks, bonds, government securities and possibly even alternative investment vehicles, including real estate. This helps reduce the risk from any one investment and shores up your portfolio against market volatility.
3. Have a liquidity plan built into your wealth plan and monitor it
Have a plan in place outlining your goals, objectives, time horizon and liquidity needs before you need it, and review your plan regularly to ensure it serves you well during various market conditions.
Don’t jeopardize your long-term investment strategy out of fear that a few bad weeks or months in the market will persist. Put simply, having a financial plan in place for what happens next builds confidence — and gives you the ability to look past today’s headlines.
This article originally appeared on MarketWatch in August 2018.