Short-term lessons for long-term success: four common pitfalls in volatile markets
Unwary investors can easily let their emotions get the better of them when the going gets tough. We outline four of the most common pitfalls investors can fall into when navigating market volatility, along with suggestions on how to avoid doing the same.
- Institutional investors are facing a challenging combination of risk factors, including inflation, rising interest rates and market volatility.
- It can be easy to make mistakes during times of stress or flee the perceived risk altogether. This can have unintended consequences for long-term investors.
- We outline some of the most common pitfalls investors make when markets get rough, along with suggestions to help avoid getting caught out.
What do grizzly bears and bear markets have in common? They both tend to make people want to run away in fear. Such a reaction is unlikely to end well in either situation, but the desire to escape danger is very real. In fact, neurologists have established a physiological link between the brain’s fight-or-flight response and how we process investment losses.1 When danger is detected, a specific region of the brain releases adrenaline, which focuses attention and puts the body on high alert. The goal of this hardwired response is to find immediate safety from harm.
Institutional investors have had their nerves sorely tested of late, first having to navigate the turmoil generated by COVID-19 and, more recently, finding themselves facing a unique combination of new challenges. Inflation levels not seen for 40 years are affecting growth, real returns, and turning central banks hawkish, while interest rates have risen at historic speeds, threatening to break out of a 40-year downward trend. This mix of factors has sent investors rushing for the exits, resulting in increasing volatility across equity and bond markets. But while the urge to flee can be powerful, it isn’t always the sensible course of action. Run from a grizzly, and you’re likely to end up as lunch. Run from volatile markets, and you risk selling at the bottom and crystallizing any losses.
In our long experience managing assets, we’ve found that market turmoil can often lead to opportunity and, historically, the disciplined investor has been rewarded by staying the course and taking advantage as conditions improve. Risks abound, however, and unwary investors can easily let their emotions get the better of them when the going gets tough. In this paper, we outline four of the most common pitfalls investors can fall into when navigating market volatility, along with suggestions on how to avoid doing the same.
1 Turning temporary volatility into permanent loss by automatically rebalancing
The main objective of rebalancing is to keep the assets aligned with the portfolio’s initial risk/return profile. During time of volatile markets however, that relationship can become broken; consequently, assessing the risk/return profile can be challenging. Rebalancing assumes that assets are more likely to increase in value when their value has decreased, which isn’t necessarily true, as past performance doesn’t necessarily predict future results. Rebalancing is just as guilty of basing investment decisions on past performance as momentum plays, whether the rebalancing occurs on a schedule or on a specified level of divergence from the target asset allocation.
Rebalancing act: how different polices could have very different outcomes
Source: Manulife Investment Management, as of September 31, 2022. Assumptions: $100 investment on January 2, 2013, end of period August 31, 2022. 60% allocation in equities (MSCI World Index, iShares) and 40% in fixed income (US Barclays Aggregate Index, iShares).
The decision to rebalance should be forward looking, based on expectations about where the markets will head in the future. If an investor decides to sell a holding, it should be because the investment thesis is no longer valid, not because it hasn’t performed as previously expected. Rebalancing also increases costs due to transaction charges incurred by frequent buying and selling. Of course, volatile markets will further exacerbate and complexify the decision whether or not to rebalance with regard to higher rebalancing costs. The support of investment professionals can therefore be key to successfully maneuvering through volatile markets.
2 Taking on unrewarded risk
All investments involve some degree of risk. In simple terms, risk is a measure of how much the investment outcome could differ from the expected outcome. In terms of strategic asset allocation, there are risks for which investors will be rewarded and others for which they won’t. The objective should be to minimize the unrewarded risks while optimizing those that could provide an additional return in the long term. Taking a short-term dynamic position on an unrewarded risk can add value, but this positioning should be tactically managed with caution.
Risk assessment: rewarded and unrewarded risks
Source: Manulife Investment Management, as of October 25, 2022.
A recent example of an unrewarded risk that’s had a significant impact for institutional investors is inflation. Inflation this year has hit peaks not seen in decades, and left unchecked, it can have devastating consequences for defined benefit (DB) pension plans, particularly those whose benefits are linked to the Consumer Price Index. In an ideal world, investors would be able to perfectly offset the effects of higher inflation in the future with asset classes that can deliver higher returns. But relying on riskier assets alone without a corresponding change in overall risk profile may not be enough to compensate for the increase in inflation.
3 Failing to accurately assess exposures
For some asset classes, a suitable benchmark isn’t always available or correctly used when evaluating manager performance. A good example is the evaluation of Canadian equity strategies, where managers are typically benchmarked relative to the S&P/TSX Composite Index or international strategies relative to the MSCI EAFE Index. It’s not uncommon to see strategies of different styles being benchmarked against the same broad index.
Not all domestic or foreign equity strategies are the same, however, and style or factor exposure can sometimes be mistaken for manager skill, especially when using such broad indexes. Style differences such as growth versus value or cyclical versus defensive, or even factor differences such as market capitalization, can be accountable for performance divergencies between a fund and broad indexes over time. This was evident in the long growth bull market that quickly reversed trend in the post-COVID cyclical run, with out-of-favor value strategies regaining leadership over more growth-oriented strategies. Investors who favored outperforming strategies coming into this rotation may have inadvertently overallocated to growth-oriented strategies and avoided or exited underperforming value-oriented strategies that would have provided much-needed diversification in that market environment.
A properly diversified portfolio should experience a mix of results across strategies through different market environments but aim to add value in aggregate over a full cycle. If all the managers in your portfolio are outperforming at the same time, make sure you’re not caught offside when the market changes course by being too heavily exposed to specific factors. As commonly stated in our industry, past performance doesn’t necessarily predict future results. Investors shouldn’t be chasing performance but, instead, should maintain discipline.
A resilient portfolio will have balanced exposures and provide levers for its stewards to pull as market environments change. It’s important to understand the drivers of alpha for each strategy and avoid making the mistake of misjudging manager stock selection skills for the inherent factor/style exposures of the stocks they traffic in. Investors shouldn’t expect managers to shift their portfolio orientation with the market unless that’s part of their investment process.
Investing in style: value vs. growth 2012 to 2022
Source: MSCI and Manulife Investment Management, as of June 30, 2022
4 Not focusing on the outcome
It’s easy to get caught up in asset performance amid periods of market volatility, but institutional investors would do well to hold their nerve and remain focused on outcomes rather than performance. An outcome-oriented approach means rather than viewing asset performance in isolation, investors would be better off doing so within the context of the objectives or liabilities they’re managing their assets against.
Let’s take a DB pension plan as an example. Its primary objective is that benefit payments, or liabilities, are made in full and on time. Since those liabilities comprise fixed payments (some linked to inflation) stretching out into the future, they have similar risk characteristics to a bond portfolio. They can therefore be valued just as we value a fixed-income portfolio comprising bonds issued by governments and corporations. It also means that the value of those liabilities will have the same inherent economic risks as a portfolio of bonds: The value of the liabilities will fall as interest rates rise and vice versa. When seen through the lens of a DB pension plan sponsor, this stream of liabilities represents a negative asset. This framework can apply to all institutions that have a future stream of liabilities or payments to be made.
As bond yields rose significantly across the board in the first half of 2022 in response to surging inflation and central bank actions, it put downward pressure on pension liabilities, thereby helping DB plans maintain a healthy funded ratio and insulating them from the implications of negative asset performance. As rates have gone up, the financial health of pension plans in Ontario, for example, has improved. According to the Financial Services Regulatory Authority of Ontario, the median projected solvency ratio continued to climb as a result of higher solvency discount rates, ultimately reaching a new high.1 These results highlight the importance of considering both the assets and the liabilities when managing pension plan risks.
In many instances, recent market developments have also presented institutions with the opportunity to crystalize the healthy financial situation of their DB plans and further hedge interest-rate risks to protect the funded ratios from future volatility and adverse moves in interest rates.
For plan sponsors that are well funded, don’t need to earn excess returns, and wish to reduce risk, recent market developments present the opportunity to lock in the healthy financial situation of their DB plans by derisking. This can be achieved by reducing their allocation to riskier assets and increasing allocation to assets or strategies that more closely match the risk metrics of their assets with their liabilities. Ultimately, it’s the desired outcome and long-term goals of the plan sponsor that should dictate decision-making.
Facing the future together
Institutions today face a host of evolving issues and challenges. Whether it’s unpredictable markets, interest-rate uncertainties, rising inflation, or a combination, managing a pension plan or endowment fund is becoming increasingly complex and can strain in-house resources. Not every institution can afford to maintain a large in-house investment department and, as a result, a growing number are seeking the help of outside expertise to provide guidance on their objectives and investment portfolio and thoughtful answers to emerging trends in the market. In addition, an investment solutions provider that’s part of a large multifaceted entity can draw on a range of resources across the organization, including actuarial expertise, macroeconomic data, and multi-asset class experience, delivering a holistic solution to institutional clients that focuses on the ultimate outcome rather than isolated asset performance.
With markets still fraught with uncertainty, it can be all too easy for investors to make mistakes as their fight-or-flight instincts are put on high alert. An experienced investment solutions provider can offer advice or a well-needed sense check while helping to navigate the pitfalls along the way. Whether you’re facing a grizzly bear or a bear market, it’s better to not have to face it alone.
1 “Quarterly Update on Estimated Solvency Funded Status of Defined Benefit Pension Plans in Ontario,” Financial Services Regulatory Authority of Ontario, March 31, 2022.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
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