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September 29, 2020

Managing your portfolio during a volatile market

With this year’s stock returns looking more like a roller coaster ride with every passing day, even the staunch believers of stock market returns are experiencing doubts about the future. After a decade-long bull market (an extended period of time when stock market returns were largely positive), it can be difficult to face the new reality of our stock market. There is (largely) well-meaning yet contradictory advice out there, and depending on where you get your news from, this year is either the single greatest opportunity or the end of the economy as we know it.

In the face of all this excitement and dread, how do you choose a plan of action? Or, if you already had a plan, is it time to switch it up? Read the tips below to figure out what the right moves—if any —for your financial portfolio should be during times of market volatility.

Make sure you are diversified

No matter what the market conditions are, a basic tenet of any good financial portfolio is diversification. It’s easy to underestimate the benefits of diversification with a bull market and it is unfortunate that many investors are now seeing the need for a diversified portfolio.

Because interest rates on bonds are so low, it can feel like you’re not “optimizing” your money by including bonds and other assets into your portfolio. However, having bonds and other assets not 100% correlated to the stock market can protect your portfolio from wild swings like the ones we are currently witnessing. To diversify your portfolio, look into assets like bond ETFs and REITs (Real Estate Investment Trusts) that provide stable cash flows and capital gains. If you’re unsure about exactly how much of your portfolio you should be investing in assets other than the stock market, a good rule of thumb is: = 120 – your age = % portfolio allocated to bonds/alternative assets

Assess your risk level

If you’re constantly stressed out about the state of your portfolio and feverishly going back and forth between holding steady or selling off your stocks, you may have misjudged your risk tolerance level when first setting up your portfolio. Your risk tolerance is determined by two factors:

Risk tolerance = ability to take risk + willingness to take risk

If either of those factors were calculated incorrectly or have simply changed over time, it might be a good time to reassess the assets you’re holding in your portfolio. For example, if you allocated your portfolio to a 90% stock allocation when you first started investing, but now have a mortgage and family to take care of, your risk tolerance level has likely shifted as a simple matter of circumstance.

We would advise you to talk to a financial planner or tax professional before reallocating your portfolio, simply because you might be triggering a tax event by buying or selling assets. It is a good idea to set up some time after a major life event (like a wedding, buying a house, changes in employment, etc.) to go over your finances and change your portfolio allocation if necessary.

If nothing has changed for you personally, don’t abandon your long-term plan

We’ve talked about why you should consider changing up your portfolio, but now we’ll make a case for why you shouldn’t. You shouldn’t make any major changes to your portfolio if there haven’t been any changes to your personal circumstances during this market downturn.

When you invest in the stock market, it should be with the aim to stay invested for the long term (5-10 years at least). This is because the true benefits of investing in the stock market are realized over a long period of time. Thanks to the magic of compounding returns, the average 4-10% returns add up to hundreds of thousands of dollars over many years. The risk of a bad year or a short market downturn is mitigated by other years when the market does better than expected.

This is why individual investors are advised not to try and time the market. No one can predict the future, and so you might be missing out on major returns if you’re holding cash waiting for the market to start looking up or if you sold at the first sight of trouble.

That said, if you were negatively impacted by the market downturn (if, for example you were laid off or your salary was reduced), your financial priorities might have changed. In those cases, it might be more prudent to beef up your emergency savings to a year’s worth of expenses urgently, before trying to take advantage of the stock market highs.

Watch out for pitfalls

Ever notice that once you learn a new word or notice a new trend, it seems to start popping up everywhere? It’s as if now that your brain knows about something, it starts looking for that thing all the time. In behavioral finance, this is called confirmation bias. Researchers on behavioral finance found that 39% of all new money committed to mutual funds went into the 10% of funds with the best performance the prior year. If you find yourself investing in the same stocks that you hear about in the media or from your acquaintances, it may be worth your while to take a step back and confirm that the investment fits within your overall portfolio and goals.

Another behavioral bias to watch out for is the illusion of control. The illusion of control bias is the tendency for people to think that they have more control than they actually do over future events. As stock markets rose considerably over the last ten years, many individual investors (and portfolio managers, not even experts are immune) may have believed that their skills in stock picking were part of the reason they did so well. This could encourage you to trade more often than necessary, resulting in increased trading costs, fees, and an unnecessary exposure to risk.

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