6 Principles for Coping with Volatility and Uncertainty

With recent extreme volatility on financial markets in mind, here are six principles for preparing and coping with volatility and uncertainty in investing.

A simple fact: volatility and uncertainty are two of the unavoidable characteristics of life.

Alas, we cannot be certain of what follows tomorrow or next week, and most of the time, we cannot control the actions of others or the actions of nature. Accidents happen. Surprises happen. Life happens.

And stock markets aren’t too different. In fact, they are a leading measuring stick for the collective uncertainty and volatility that we face in our lives.

Our current global predicament is a useful case in point. Pandemics begin as a localised uncertainty, but become an international uncertainty. Stock markets typically twitch first in the face of this information, reacting a long way before that uncertainty arrives at our doorstep. But as we’ve seen, such stock market twitches can be extreme even by their own standards.

When we face extreme volatility in investing, we must be prepared for it. And not only must we be prepared for it to happen in the first place, but we must be prepared for the challenge to our rationality that often accompanies it.

Preparing for Volatility

#1: BUFFER: Make Provisions for Emergency

That journey should begin before we invest at all.

Before investing in stock markets, property or anything else, we need to ensure we have a buffer of cash. This provides essential protection in the event that times turn tough.

A good starting point is a cash balance of 6 months’ living expenses and some contingency cash to capitalise on market lows. This may sound a lot, but you will be thankful for your prudence if and when things get challenging during a recession.

#2: SELF-ASSESS: Objectively Assess Risk Tolerance

As we consider where to invest, we need to assess our risk tolerance and get comfortable with the idea of volatility.

Of course, where we are in the personal finance life cycle counts. If we are 30 years away from retirement, typically we are willing to accept a higher level of risk for stronger growth over the long run. Conversely, those closing in on retirement are typically advised to de-risk their investments to protect accumulated wealth.

But there is another important point here: preparing for the daily volatility and ensuring you can either stomach it or ignore it in favour of a long-term view.

Take the S&P 500, a stock index of 500 large companies in the United States. The historic data shows us just how much daily volatility we’ve seen over the last century. Putting recent volatility into perspective, we have seen nothing like the consistent volatility of the Great Depression of 1929 yet, but recent daily movements are similar in scale over a shorter period.

But here’s the punchline: despite all the daily noise, stock indexes have typically delivered annualised inflation-adjusted returns of more than 7% over the last few decades. While these returns are not guaranteed in the future, if we are to realise such returns, one thing is certain: we must be prepared to stomach big daily swings.

#3: DIVERSIFY: Spread Your Baskets

The most important mechanism for reducing volatility in practice is diversification. As we increase the number of stocks in a portfolio, we can reduce our level of idiosyncratic risk exposure (that’s specific risk related to companies). In theory, once we have diversified enough, all that remains is the market risk.

But diversification needn’t be limited to one country or asset class. As we’ve already seen, the stock markets – even if diversified across an index fund – will still experience significant day-to-day volatility. Diversifying by country and asset class can also be helpful in reducing variability, but may come at the cost of lower returns. In making this assessment, this is where understanding our risk profile is so important.

Coping with Volatility

#4: CHECK: Recognise Your Predictable Irrationality

So you’re in the midst of extreme volatility. Markets are moving daily at unprecedented rates. Opportunity knocks. Disaster looms.

Or perhaps it’s neither.

Perhaps all this volatility is making everything feel exaggerated. Perhaps the long-term picture is much more important.

It’s remarkably easy to get sucked into the psychology of the herd. And that’s why it’s remarkably important to check ourselves when confronted by it.

Take stock. Avoid panic. Recognise your irrationalities. Don’t catastrophise without objective evidence to back it up. Look for opportunities as well as problems. And remember: history tells us that things eventually always get better.

#5: CALM: Avoid the Urge to Hokey Cokey

If you happen to find the bottom or get out at the top, the chances are that you’ve got lucky. Why? Because markets are rather efficient reflectors of information – and that makes them difficult to beat.

This is one of the best arguments for everyday investors saving for their futures to avoid diving in and out of the market during a period of extreme volatility – and full stop, for that matter.

Better to make an objective assessment of the circumstances and take a consistent position. And that position perhaps needn’t even change. Those sticking with investing undeterred over the long-term may come out of the current period of volatility best.

Key Concept – The Efficient Market Hypothesis (EMH): EMH is an academic hypothesis that states that financial markets efficiently reflect all available information. The implication is that we cannot consistently “beat the market” since prices will only react to new information. The idea has support from those following low-cost passive investing strategies, but has come under some criticism from the behavioural economics field.

#6: ACCEPT: Make Peace With What You Can’t Control

When confronted with a blur of volatility and breaking news, it is tempting to become hypervigilant: to check our investment balances every day or hour, and watch as our digital wealth soars or crashes. It’s also tempting to do the opposite: to put our heads in the sand and hide from the reality.

But the truth is that there is no sense in doing either. Instead, we must find the middle ground between hyper-vigliant meerkat and state-of-denial ostrich.

In practice, that means keeping an eye on things, ensuring we are aware of major market shifts, but not utterly engrossed and obsessed. It means making peace with what we can’t control. And we cannot – try as we may – control the direction of the stock markets each day.

Take the Quiet Road

We are in uncertain times. Everybody has something to say and something to predict. As we stare down the barrel of news and further inevitable volatility in financial markets, I encourage you to take one thought above all else from this article: ignore the noise.

Find the information you need to take informed decisions for you, and ignore the rest. Take the quiet road. You’ll be better off for it.

Summary:

  • Volatility and uncertainty are an unavoidable feature of various asset classes, most notably stocks.
  • Before investing, it’s important to put aside a buffer for emergencies and assess the level of risk you are willing to tolerate.
  • Diversification is a powerful way of reducing unique risks, but will not eliminate volatility altogether.
  • Before panicking in the face of extreme volatility, we should have a heightened awareness of our psychology, resist the temptation to dip in and out of markets, and accept what we can and can’t control.

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