Keep Calm and Carry On: What To Do When Markets Go Down
The ups and downs of the market, otherwise known as volatility, are a normal part of investing, but that doesn’t make it any easier to stomach when the markets experience significant downward swings. The early weeks of August were a reminder that investing in equities can sometimes be a roller coaster ride. As with roller coasters, market rides are not for the faint-hearted.
Experiencing financial stress in our lives at the same time, can increase the likelihood that we will make a rash decision based on our fears. The rational reasons for why we chose to invest in the first place take a back seat to our fears. Research in the financial therapy and behavioral economics fields has shown that in times of crisis, our primal fight, flight or freeze responses take over, - pushing the rational, analytical part of our brain to the background.
Let’s first review the main factors that affect how your portfolio will perform during down markets. Then will take a look at what you can do to help minimize the possibility of making emotional decisions when the markets take us on unwanted roller coaster rides.
Volatility and Risk
Volatility, as defined by Investopedia, is “the statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security.” More simply put, the larger the range between ups and downs, the riskier you should expect the investment to be. Although volatility and risk usually go hand in hand, they aren’t necessarily bad things. Typically, the riskier the investment, the bigger swings you should expect. The potential reward for taking on the extra risk and stomaching the swings is a higher return. Without this potential reward, you would be inclined to invest in more stable assets that are likely to minimize your risk and decrease the size of the swings, such as U.S. T-Bills. Think of the more stable asset classes as the kids’ roller coaster at the amusement park, it doesn’t go as high so the drops aren’t as significant. However, the cost of decreasing your risk and volatility is typically lower returns over the long term. For example, the safety and relative stability of the U.S. T-Bill is why it’s return is potentially much lower than say the rising stock of a young tech company.
Asset Allocation – Your BFF During Down Markets
Asset allocation is a fancy way of saying how much do you have in each of the three main asset classes – equities, fixed-income and cash/cash equivalents. Asset allocation is use to balance risk and reward by setting allocations based on your risk tolerance – ability to handle the ups and downs; your risk capacity – how much risk do you need to take to meet your goals; and your time horizon – how long before you need to withdraw funds. Asset Allocation can be your friend during times of turbulence. If equities go down -20% and you’ve allocated only part of your portfolio to equities, you’ve dampened the impact of the downturn. To illustrate, let’s use a simple hypothetical scenario. Let’s assume you have a $100,000 portfolio invested 100% in a S&P 500 index fund. The S&P 500 index fund goes down -20%, you lose $20,000. However, take that same $100,000 and assume 40% is invested in a S&P 500 index fund and 60% in cash. Assuming a 0% rate of return for cash, you only lose $8,000. Your lower allocation to equities has reduced the impact of the loss on your total portfolio
Diversification – Your Other Friend
Simply put, diversification, is how you reduce risk in your portfolio by investing in a wide variety of investments, hoping these investments will not react the same. It’s can be summed up by the common phrase “Don’t put all your eggs in one basket”. Asset allocation is the first step of diversification. After you determine that, you can then decide how to invest within each asset class. For example, for your equity allocation, you can decide to invest in international or emerging markets stocks in addition to U.S. stocks. Additionally, within each of these areas you can break your allocation down to large cap, mid cap or small cap stocks. You can breakdown it down further by value vs. growth stocks. You are trying to spread your risk out among different investments that may not perform the same as each other or may have exposure to different risks. This is the equivalent of adding more baskets to hold your eggs and putting some eggs in each basket. If one basket falls and your eggs break, you still have the other baskets.
If we use the example above, our 40% equity allocation is invested 25% in a S&P 500 index fund, 10% in an International Index fund and 5% in an Emerging Markets index fund. Let’s assume a hypothetical scenario in which the S&P index fund loses -20%, the International index fund earns 5% and the Emerging Market index fund earns 20%. Cash earns 0%. The $100,000 portfolio allocated 40% to equities and 60% cash, loses only $3,500 instead of $8,000 as above. This is because you put your equity eggs in different baskets. In our hypothetical scenario only one basket, the S&P 500 index fund, fell over.
The markets are falling, our stress is high and our brain is in a war with itself.
What To Do So You Can Keep Calm And Carry On
The markets are falling, our stress is high and our brain is in a war with itself. One part is telling us to sell to protect us from further loss. This part is emotional and it is very loud and very aggressive, it’s pushing the rational part of brain that wants to analyze the facts before making a decision to the background. We need pause, take some deep breaths and let the rational part of our brain regain control. Once we are thinking clearer, we can decide what to do. Most of the time it will be to do nothing. You recall you have a sound investment plan based on your current and future financial goals. You knew there could be swings in the market based on how you invested as this was bound to happen at some point. You’ve prepared for this through your asset allocation and diversification strategies.
However, you can take some steps that will hopefully help minimize the impact of the emotional part of your brain winning the battle in future market declines. Below are a few strategies to consider:
- Think about how you really felt during this latest downturn and how you felt once markets bounced back. Write a personal note to your future self, reminding yourself how you felt, that you are committed to staying invested for the long-term and your decisions were based on objective information. Add this note to your Investment Policy Statement – this is the document that you created to determine how to allocate your portfolio based on your risk tolerance, risk capacity, goals and time horizon. Adding it to your Investment Policy Statement will make it easily accessible when your anxiety starts to run high during the next stormy market.
- If you haven’t already set an upper and lower limit for the percentage of ownership for each asset class, consider setting these limits as guide rails to help you decide what to do. If the asset class that has gone down is still within the predetermined range, you will sit tight. If it’s lower then the bottom range, then now might be an opportune time to re-balance. You’ll be locking in the return on the investments that had positive returns and buying investments that had negative returns at lower prices. These guidelines will also be used during your regular re-balancing to keep your asset allocation aligned with your risk tolerance.
- If it’s a significant market correction – usually defined as a 20% or more drop in prices over a 30-day period, now may be another opportunity to re-balance. Again, locking in gains and buying at a discount.
- If upon review, you have decided that the risk was more than you can handle, review your asset allocation to determine if you should lower your exposure to equities to lessen the impact of future downturns.
- Additionally, review your diversification strategy. You may want to lower or eliminate your exposure to the riskiest assets in your portfolio.
- Review your timeline. Has your investment time horizon shorten? If your time horizon is still 10 years or more, you don’t really need to worry. The ups and downs of the markets are just noise distracting you from your long-term goals. If your time horizon is less than 2-3 years, consider setting aside cash reserves to meet the first 1-2 years of withdrawal needs. Research has shown that you are most vulnerable to a market downturn within the first few years of retirement. Adding the need to re-balancing to raise cash can compound the effect. By setting aside cash to meet your withdrawal needs, you can increase the likelihood that your portfolio can recover prior to making the first withdrawal.
- Stop watching the daily market talk shows. Their advice may be sound good but is it really the right advice for you? They talk in generalities and not with your specific situation in mind. Don’t let the melodrama of the market, which makes from good news coverage, influence your well-though out and intentional plans.
- Call you advisor to talk about your concerns and review your investment strategy, financial plan and goals. Now might not be the time to take action, but it’s good to note and at the appropriate time change your allocation to make the next downturn more bearable.
If you have invested based on your risk tolerance, risk capacity, financial goals and time horizon then the impact of any market volatility is just par for the course for the investment strategy you have chosen. It’s expected and has been accounted for as part of your overall investment strategy and financial plan. Then next time the market takes you on a roller coaster ride, take a deep breath and remember that the ride will end and you will feel better when you get off.
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