How to survive market volatility

Share markets around the world have sold off sharply. The immediate trigger was weaker than anticipated US jobs data that sparked concerns over the possibility of a recession in the world’s largest economy. Other data has been disappointing too. There are worries manufacturing is weakening and that US consumers are about to hit the spending buffers because they have exhausted their post-Covid build-up of savings.

With the US labour market’s slowdown becoming clearer, expectations increased the US Federal Reserve might cut interest rates more aggressively, putting pressure on the US dollar. Simultaneously, the Bank of Japan raised rates to control inflation, buoying the yen, which has led to a reversal in the so-called ‘carry trade’ of borrowing cheap yen to invest elsewhere. When this happens traders must quickly sell assets to cover currency losses, which causes ripples across all markets.

In a cascade effect of investors having to sell down positions it’s often the ‘crowded trades’ and previously top performing areas that bear the brunt of falling prices. It’s no surprise to see tech stocks, which many have said were previously ‘priced for perfection’ at the heart of the volatility, alongside speculations such as crypto assets. Those leaning too far on one side of the boat and taking a less-diversified approach have been punished, at least in the short term.

With huge media attention and minute-by-minute commentary it’s easy to be rattled, but it’s important to keep a clear head. It’s worth noting too that thinner summer trading that can lead to additional volatility around economic news, so although daily price moves can appear scary, this is normal in the context of stock markets and it’s important not to react with haste.

At these times it is usually best to keep calm, stick to your investing plan and keep focused on the fact that sharp short-term moves should pale into insignificance over multiple years and decades. It’s rather like avoiding sea sickness by keeping your eyes on the horizon rather than the rolling waves below. Although there could be further volatility ahead the destination is what matters rather than the journey, even though it can be stomach churning at times. For what it’s worth we believe a ‘soft landing’ scenario whereby the US avoids recession is still very possible, which may be supported by other data as it emerges in the coming weeks and months.

Eight tips to prepare a portfolio for market volatility

1. Stay calm

Volatility is an inevitable part of investing; a necessary evil and investors must always be prepared to ride the ups and downs. Keeping everything in cash is the most secure thing to do in the short term but keeping too much in the longer term it is likely to be a poor decision. Inflation could gradually erode its spending power. Through compounding more volatile stock market returns, and ignoring short-term noise, you give yourself a better chance of meeting long-term financial goals.

It’s often the case that the market falls more quickly than it rises, which is psychologically challenging. It’s particularly bad luck if you have just invested a lump sum, but there is consolation from the fact that time spent in the market is far more important than timing the market over long periods, so as long as you have a long term view you shouldn’t be too concerned.

2. Don’t make changes in haste

Selling out in fear can be the worst thing to do. Large falls can be followed by large rises, so you risk losing on both sides – selling when prices are depressed and not buying in until they have moved higher. Sadly, this is a trap that many investors fall into. Being out of the market also means you are no longer collecting – and potentially reinvesting – any income your investments are paying. In the absence of a crystal ball, keeping invested is often the best strategy, no matter how uncomfortable.

Daily monitoring during a falling market can result in an over-emotional reaction and make rational decisions difficult. If you have a well-diversified portfolio of collective investments such as unit trusts and investment trusts, as well as a strategy you are happy with, then a less regular (for instance monthly) check should be sufficient.

3. Invest regularly to capture lows as well as highs

If you have been keeping some cash in reserve, market volatility could be an opportunity to consider investments that you previously thought were too expensive. Often the market overly punishes certain areas as panicking investors sell everything they can. This can present opportunities.

If you are thinking about investing but are nervous of the current conditions, one way to counter market ups and downs, as well as take some of the stress out of investing, is to contribute money at regular intervals, say once a month, rather than a lump sum in one go. The advantage of dripping money into the market is that you don’t need to worry about market timing. The strategy can even turn market volatility to your advantage as you average down if prices fall further. There’s more on this in my article on regular investing: How to invest little but often.

4. Get your plan on track

Sudden market turmoil after a calm period can reveal just how volatile certain investments in your portfolio can be. If this is a shock you weren’t prepared for it may be time to revisit whether you have too much in the most volatile assets. You could add areas to diversify to help smooth out returns, though bear in mind this may dilute the long-term potential of a higher risk portfolio and that any changes should be thoughtful and measured rather than made in haste.

When you invest in the stock market you are buying into stakes in companies. As a shareholder you participate in the growth of the business if it does well and often receive a share of the profits through dividend payments. Sharing in the profits and growth of companies means your capital is potentially exposed to losses, but over long periods of time history shows that investors often benefit from taking these risks. Striking the right balance between risk and reward is something every investor must consider and revisit periodically – it’s important that you make the most of your money, but without losing sleep over it.

It can therefore make sense to build in more stable assets to help temper the big ups and downs the stock market inevitably provides at times. It is notable that bonds have provided some protection to portfolios recently. They have risen while stock markets have retraced, underlining the diversification benefits of this asset class.

5. Adopt a ‘permanent’ diverse portfolio

Timing the market, moving into and out of riskier assets, is exceptionally tricky, so a more realistic alternative is to have a more permanent and properly diversified portfolio that is rebalanced and perhaps tilted one way or another according to the general outlook, specific opportunities and perceived risks. This approach keeps you invested to benefit from the long-term wealth generating effect of asset prices without betting the farm.

As investment legend Sir John Templeton put it, “The only investors that don’t need to diversify are those that are right 100% of the time”. The sensible thing to do then is to prepare for different outcomes and spread your money around so you are not reliant on a single company or investment area. In other words, have a big enough umbrella for when it rains.

By blending a variety of investments that are ‘uncorrelated’ (i.e., their price movements are largely independent of one another rather than moving up and down in tandem) it is possible to build a portfolio more resilient to market fluctuations but that can still deliver good performance. Ideally, this should balance simplicity with variety. Spanning different sectors and areas is important to spread the risk, but equally a portfolio shouldn’t become an unwieldy ‘stamp collection’ difficult to monitor and manage.

6. Stick to your strategy

Rather like becoming seasick from rolling waves, market volatility can test the resolve of any investor. When at sea, keeping your eyes on the horizon, rather than on the churning ocean below, allows you to rebalance your senses and regain your orientation. As an investor if you keep focused on the long term rather than every passing market gyration you stand to make better decisions about what to do next.

Hopefully you will already have a plan for how much money you are investing, or seeking to invest, and which areas it is allocated to. One that is in harmony with your objectives, time horizon and level of risk you are happy with. If you have a good handle on what your ‘permanent’ portfolio should look like, it may sometimes make sense to adjust these allocations as asset prices move around to maintain weightings and diversification. However, for much of the time little or nothing should be required.

Either way, if you have a plan to stick to and accept that events will inevitably arrive to test your resolve it can make things easier. Otherwise, there could be a tendency to slip into panic mode and make poor, spur-of-the-moment decisions. At times of market stress, emotional reactions from investors can mean price falls are exaggerated, which makes it more difficult to think rationally. In these circumstances be aware that buying or selling in haste can result in being on the wrong end of price swings.

7. Include income-producing investments

Although it can be scary when the markets are volatile, the amount of income an asset produces can often be more consistent than the capital value. Amidst a challenging and fast-changing economic backdrop it is easy to forget this is an important part of your overall return.

When markets are flat or falling the steady arrival of income adds to and stabilises the value of your portfolio. Income from your share or bond holdings is also a reason why timing markets, selling out then buying back in, is usually unwise as it interrupts the flow.

As well as dividend-paying shares, to balance the choppiness of share markets and help smooth overall returns, investors often add traditionally less-volatile bonds.

Typically, bonds pay a fixed amount of income each year (known as a coupon) and repay the original capital at the end of the term. It’s an asset class that attracts investors looking to take some risk with their capital in exchange for the prospect of a higher longer-term return than cash. You can find out more about this on our latest bonds and fixed income sector review.

8. Plan to use market falls to your advantage

Buying when asset prices are low and selling when they are higher is always the aim with investing, but it can be difficult to achieve without time and patience. Many people end up making emotionally led, shorter-term decisions and doing the opposite. However, a large fall could be just the opportunity you have been waiting for to invest in an area you have had your eye on but felt was too expensive.

Some more active investors like to keep a little ‘dry powder’ to capitalise on any market turbulence, particularly when markets are looking expensive. This could, for instance, be through holding very safe investments such as money market or short-term bond funds that can quickly be sold and reinvested into riskier areas at opportune moments. However, market timing is notoriously hard and tends to require luck as well as judgement.

Market tops and bottoms have much to do with human psychology, as well as many factors we aren't aware of at the time, so this strategy comes with the risk that you miss out from not being more fully invested over the longer term.