Navigating volatile markets: four common pitfalls
Market swings are unsettling for any investor, and high emotions may lead to investment mistakes. We outline four common pitfalls to look for when navigating market volatility.
- Investors continue to face combined risk factors, including inflation, interest rates, and market volatility.
- It can be easy to make mistakes during times of stress, especially while attempting to flee risk. This can have significant unintended consequences for long-term success.
- Avoiding common pitfalls can help to prevent further damage to portfolios in already difficult market conditions.
Volatility is likely to continue in the short term and, being the start of the year, many investors may feel the urge to make changes to their investment portfolio. However, it’s important to consider several factors to avoid making common mistakes.
Pitfall 1: Failing to minimize unrewarded risk
Resilient portfolios are those that are structured to weather changing market cycles and that are built around identifying risks that have the potential to reward investors—and optimizing exposure to those within a portfolio—while aiming to lessen exposure to unrewarded risks, such as inflation.
One way to help investors build resilient portfolios is to combine strategic asset allocation—guided by long-term expected asset class returns—with an ability to actively tilt toward asset classes that can help optimize a portfolio’s exposure to shorter-term trends.
Risk assessment: rewarded and unrewarded risks
Rewarded investment risks
Strategic objective: optimize
Unrewarded investment risks
Strategic objective: minimize
Inflation is one risk driving market volatility, and investors became acutely aware of its negative effects in 2022 as the core of portfolios—both equities and bonds—lost money. Strategies to reduce exposure to inflation as an unrewarded risk can include increasing exposure to alternatives, such as a basket of diversified liquid alternative strategies that aims to outperform at different times in a market cycle. Different alternative strategies have different objectives, such as to enhance returns or protect on the downside, which is why diversifying between strategies is optimal. When compared with the portfolio protection that investors generally expect from fixed-income holdings, alternatives offer merit as an addition to a well-diversified portfolio.
Pitfall 2: Failing to assess market conditions before rebalancing
Portfolios that are set to rebalance on a scheduled basis, such as monthly, quarterly, or yearly, potentially miss a critical component, which is an assessment of market conditions. A key objective of rebalancing is to keep a portfolio aligned with its intended risk profile. However, during periods of short-term volatility, a portfolio’s risk profile may be fluctuating more than usual, requiring an investment manager’s careful assessment of the most optimal rebalancing strategy, which could also include no rebalancing for a period. Automatic rebalancing, especially in volatile markets, may hurt—rather than help—a portfolio.
A more active—rather than automatic—approach to rebalancing involves regular, disciplined monitoring and review of a portfolio while retaining the option of when to rebalance depending on market conditions and portfolio positioning.
Pitfall 3: Chasing performance
Investors naturally want to maximize returns and, particularly after a year of significant losses in equities and bonds, may be tempted to pile into asset classes that have outperformed or show early signs of recovery, at the expense of remaining diversified. Investor behavior is subject to recency bias in both up and down markets. Deviating from a diversified approach to chase performance may expose a portfolio to a higher risk of losses at a time when volatility remains high. As an example, the reversal of the performance of growth stocks in 2022, with double-digit losses following double-digit outperformance in 2021, is a reminder that gains can be quickly lost if markets move against factors that have been dominating. The aim of a properly diversified portfolio is to provide a mix of results across strategies, factors, and styles through different market environments with the aim to add value in aggregate over a full cycle: in other words, providing consistency of returns—and therefore delivering resilient portfolios—through market cycles.
Gains from growth stocks in 2021 reversed in 2022
S&P 500 Growth Index, S&P 1000 Pure Value Index, 2/6/20–2/6/23
Source: S&P Global, February 2023. Data has been rebased at 100. The S&P 500 Growth Index tracks growth companies in the S&P 500 Index. The S&P 1000 Pure Value Index is a subset of the S&P 1000 Index and includes only those components that exhibit strong value characteristics. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Pitfall 4: Losing sight of the end game
Investment losses amid periods of market volatility are stressful for any investor. But it’s important for investors to hold their nerve and remain focused on their goals, whether that’s to save for their children’s college education, their own retirement, or to build wealth. Panic selling in down markets locks in losses and excludes investors from the potential of the strong returns that often occur at the onset of a recovery. It’s important to be reminded that, historically, downturns are followed by recoveries, oftentimes sooner than investors anticipate. For example, the global financial crisis had one of the deepest drawdowns in history with the S&P 500 Index down 51% at its lowest point. Even with losses of this magnitude, a diversified portfolio was able to fully recoup losses within three years.
Facing the future together
Financial professionals and investors face numerous evolving issues and challenges, whether it’s unpredictable markets, interest-rate uncertainty, inflation, or a combination. Navigating the investment landscape is increasingly complex and requires ever more professional resources to thoroughly research opportunities and risks. With uncertainty in markets remaining high, it can be all too easy for investors to make mistakes, which is why the guidance of an investment team that’s experienced in asset allocation across multiple asset classes can help investors to weather short-term volatility and remain focused on long-term successful outcomes.
Drawdown is a measure of market declines from a peak to a subsequent trough.
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