Investors need equity returns to build wealth over the long term. Unfortunately, sometimes investors find it difficult to endure the sharp declines and volatility that is often experienced in capital markets. Market movements can be gut wrenching worse coupled with loss aversion.
Humans experience loss much more intensely than gains (loss aversion). Loss aversion is the tendency to avoid losses over achieving equivalent gains. Broadly speaking, people feel pain from losses much more acutely than they feel pleasure from gains of the same size. Loss aversion bias typically shows up in financial decisions: people often need an extra and sometimes significant incentive to take financial risks that might result in a loss. Knowing this about ourselves makes it easier to take emotion and negativity out of the process and to trust the system.
As an investor, one should understand that risk is necessary to pursue higher returns. However, the correlation between risk and reward illustrates those higher returns, more often than not, experience higher volatility. This leads to the important subject of how to react in a turbulent environment.
Market movements are inevitable when it comes to investments, what is important to o keep calm and take advantage of opportunities created by volatility and dislocations. Patience is a virtue that investors must cultivate. Winning investors are those who will patiently wait in until the storm is over. Investment market crashes are bad but the market will always bounce back and sustain long term growth. Do not just automatically jump ship when things go south. It is during these when the market is down and experiencing some dislocations and with right fundamentals, fortunes have been made by savvy investors who have pounced, when prices dropped, only to be rewarded when the market steadied.
For an investor safety is as important as growth. Prudent risk management therefore requires that one addresses the possibility that a ‘’Bull’’ market could turn ‘’Bearish’’ at any time. One’s investment portfolio needs to be prepared should unfriendly market conditions occur. During turbulent times in stock markets investors are looking for answers about what they should do. The answers however depend upon who is asking the questions. If the questioner is a speculator who buys and sells stock with the focus on their momentary prices then it may be difficult to offer a solution as successful market timing is near impossible. If on the other hand, the question is coming from a long term investor, there are quite a number of ways to prepare for turbulent times.
It is important not to let market uncertainties affect financial planning for the years ahead. Individuals who stop their investment planning, particularly during market downturns, can often miss out on opportunities to invest at lower prices. Nobody has all the answers to why the market takes a nosedive, but it is often useful to take a look at the economic precursors that may play a role in market turbulence.
Uncertainty is a constant, and downturns happen frequently. But market setbacks have typically been followed by recoveries. An investor should stay disciplined as trying to time the market as proven to be challenging and costly. An investing approach built with one’s goals and situation in mind may help one cope with short term volatility. A defined investing plan tailored to one’s goals and financial situation can help one be ready for normal ups and downs of the market at to take advantage of opportunities as they rise.
Attempting to move in and out of the market can be costly and the decision investors make about when to buy and sell can investors to perform worse than they would have had the investors simply bought and held the same investment. If one invests regularly over months, years and decades, short term downturns will not have of an impact on the ultimate performance.
If one keeps investing through downturns it will not guarantee gains and that they will never experience a loss, but when prices do fall they might actually benefit in the long run. When the market drops the prices of investments fall and the regular contributions allow one to buy a larger number of shares. In general the best time to enter the market to a tail risk premium is after periods of left tail risk, that when there is blood in the streets, while the best time to exit the market is when future or forward looking left tail risk is high (a prediction of severe downside losses).
Following closely market valuations and moments of high volatility helps in making wise investment decisions. It is advisable to keep abreast with market trends for purposes of diversification, asset allocation and rebalancing. By taking risk, one would simply be exploring the unexplored and on some occasions find the hidden treasure unseen by many. Remember, high risk, high return! However, do keep in mind that some investments may be more volatile than others. Which one to choose from is purely based on an investor’s risk appetite. A risk averse investor usually opts for a less volatile portfolio as opposed to a risk-seeker who may prefer a portfolio which is more volatile.
Finally, if the movement of the markets have changed your mix of large-cap, small- cap or the mix of stocks, may need a rebalance to get back to the target asset mix. That could provide a disciplined approach that helps one to take advantage of the lower prices.
If you are invested in a diversified portfolio there is a chance that some assets in your portfolio will go up while others go down. At the end of a quarter or year, the portfolio you built with careful planning will start to look quite different from what it was initially. Do not get too far off track. Check it regularly at least once a year to make sure that your investments still makes sense for your situation and that your portfolio does not need rebalancing. Staying focused on the long term and rebalancing and reviewing one’s portfolio are not at odds with each other. Circumstances change and what’s relevant to you in your thirties is almost certainly not 10 years down the line.
Through, rebalancing investors will strive to realign weightings of their portfolio assets. This involves periodically buying or selling assets in a portfolio to maintain the original desired level. Market movements can expose an investor’s portfolio to greater risks or lower return opportunities. Hence, rebalancing entails the sale of high-priced or low-valued securities and deploying the proceeds into low-priced and high-valued ones. Continuous rebalancing at certain time intervals enables investors to stay on track of their investment objectives. Investors can embark on portfolio restructuring taking advantage of market dislocations, sell-offs and review asset allocation strategies.
It is also important where possible for investors to maintain adequate dry powder or liquid reserves that can be deployed when market volatility causes markets overshoot on the downside or to gradually average in to larger allocations. This will help on portfolio liquidity and as well as tail risk strategies.
Rather than focusing on the turbulence, wondering whether you need to do something now or tomorrow, it makes more sense on developing and maintain a sound investing plan. A good plan can help you ride out the peaks and valleys of the market and may help you achieve your financial goals. You can battle quicksand with quick thinking.
Although volatility should be of concern to investors, bouts of market volatility can create attractive opportunities that add a return premium when securities pricing becomes divorced from fundamentals. There is reason for a cautious optimism among investors revisiting their attitude towards volatility for long term portfolio construction and rebalancing. Careful overall portfolio positioning can be used during periods of market volatility and dislocation. Instead of being worried about market volatility be prepared for volatility.
Until next week enjoy making money on capital markets.
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