The five principles for surviving market volatility

1.  Know what you don’t know.

You won’t be able to predict when markets will become volatile. There are simply too many variables. All the predictions in the media can be undone by government policy changes, acts of nature, political changes, wars, supply shortages and trade disagreements. Experienced portfolio managers consider multiple factors in their analysis and, knowing this uncertainty, are generally conservative in making changes. That is, they know what they don’t know.

When you break down the elements of trying to time market volatility, this measured approach makes sense. Consider the decision to “go all cash.” If you have a 50% chance of being right on selling to cash, you have a 50% chance of missing a big loss or missing a potential gain. But… you then have to get the timing right on re-entering the market. If you have a 50% chance of being right here (avoiding even more loss and getting a big gain), that’s another source of uncertainty.

Using that framework, here are a few possible outcomes of timing your investments:

Perfect timing: Missing the loss, re-entering the market at the bottom and participating fully in a subsequent recovery
OK timing: Missing half of the loss, re-entering the market halfway through a subsequent short-term gain
Trapped-in-regret timing: Capturing all of the loss (by selling at bottom), waiting for a sign of improvement, remaining indecisive, and missing most of a subsequent recovery

2. Embrace asset mix.

Your mutual funds may hold equities (or stocks). When equity markets become extremely volatile, global markets tend to become more correlated – that is, they move together more closely. This is temporary, but still unsettling. It creates a feeling of “nowhere to hide” within equities. Asset class diversification – that is, your mix of bonds and equities – can provide you with some protection. In general, bond mutual funds are less volatile than equity funds. When you set up your investment plan with an advisor, they can help you establish a mix (or portfolio) that takes several things into account:

• Your age
• Your goals
• Your tolerance for risk
• Your timing – when you need the money

3. Learn about volatility – and how to manage it.

There are additional ways to reduce volatility in your investments. Mutual funds come in many varieties, and each fund has a risk rating that you can find in its Fund Facts (available on fund company websites). This rating is based on how much the fund's returns have changed from year to year. It doesn't tell you how volatile the fund will be in the future, and it can change over time. And, a fund with a low risk rating can still lose money. But this is one of the benefits of reviewing Fund Facts as you consider investments.
Your advisor is in a position to evaluate mutual funds and combine them. They may recommend funds that are designed to have less volatility than the equity markets. These are called “low-volatility” equity funds. Or, advisors may recommend funds with a track record of avoiding the full impact of previous market downturns. These are funds that have low “downside capture,” meaning that when markets decline, historically, these funds have declined less. This is not an indicator of the future, but it does show evidence that a manager has not been duplicating the market. There may be a trade-off in emphasizing lower volatility. In some cases, you won’t participate in the full upside of the market.

Lastly, there are mutual funds called “managed portfolios” or “managed solutions” which not only spread your risk across many asset categories, they also may make small changes in the asset mix in the short term to reduce risk. This is called “tactical asset allocation.” Not all managed portfolios use tactical asset allocation, so it is something to discuss with your advisor.

4. Get to know guarantees.

Many Canadian investors want to participate in the growth of the markets, but are willing to sacrifice some return in exchange for slightly higher fees that pay for insurance guarantees. Advisors can help investors put all or just a portion of their portfolios in investments like segregated funds. These products can provide maturity and death benefit guarantees, estate planning benefits, potential creditor protection and the potential to bypass probate.

There are also investments such as annuities and GICs, which have no equity market risk. Annuities provide guaranteed income for life or for a specified period. They have their own trade-offs, where investors give up the market’s potential upside in exchange for certainty. Here again, advisors can recommend a product mix, and their recommendations will be based on both your needs and the investment environment.

5.  Accept that loss aversion is real.

One of the key lessons of behavioural economics is that, on average, people dislike losses twice as much as they enjoy gains. This is a well-researched phenomenon, and you may not be able to “reason” your way out of it. So, if your portfolio value is significantly down from its high, it’s very likely going to trigger frustration, fear, anger and regret. Prepare for these reactions, and try to focus on your goals and timeline. Your advisor can help you understand your options. They are there for you in good times and bad. One simple rule of thumb to consider is this:

Time in the market is more important than timing the market.