How to handle volatility

Capital at risk. The value of your investments can go up and down, and you may get back less than you invest.

All investing carries risk. It might seem daunting but we’re not talking about closing our eyes and crossing the road. In investing terms, what we are really asking is how likely it is we’ll end up losing money on an asset if we invest in it.

We could try to take that risk right down to the lowest level possible but that might hinder how much an investment could grow - the old risk/reward scenario. Some of today’s tech titans carried huge risk when they first started out but if you had caught them at the ‘garage and all-night coding’ stage, the reward now would be truly something. The other side of the coin is maybe a huge conglomerate that doesn’t tend to grow by much but feels extremely unlikely to go out of business.

While we’re always trying to figure out what balance suits us and our own investment personalities, we have to get used to the fact that no matter what journey we take it won’t be a simple straight line to those hopeful returns.

Volatility is much more about the everyday rises and falls than the long-term risk profiles associated with assets like stocks and bonds. It tends to grab our attention most often, with news channels constantly flashing up big changes in stocks and indices. It’s not the healthiest thing to be swayed by headlines everyday, though. In fact, volatility can become a real enemy if we don’t view it the right way. Here are seven tips to get yourself in the right mindset, ahead of any heart-pumping market moments.

The big thing investors will recognise when the markets suddenly become volatile is their emotions kicking in. We like to think of ourselves as cold, rational operators in the face of uncertainty but the truth is we tend to let instinct take over. That’s not a great situation, as we’re more likely to react through fear or greed than adhere to solid investment principles.

One way to mitigate that is to reduce as much as possible how much you’ll need to engage with your portfolio when the charts get spikier. That starts long before it happens.

Once you set your course by deciding your time horizon, tolerance for risk and how much you want to invest, and get the assets to match, try not to fiddle with your account. What happens on the journey might look exciting but, ultimately, if your asset mix does its job well and grows, it’s the end result that matters.

We can be our own worst enemies at times of heightened volatility so reducing your ability to jump in and act on emotion can be a useful tactic.

As beautiful as it is simple, it’s an incredible piece of investment guidance from Fidelity legend Peter Lynch. Not only is it generally a good steer to understand what you’re invested in but it will help you assess the picture when times get tough. Is your company simply getting tossed around by wider market forces or can you see something genuinely wrong in the business? Is it a share price overreaction? You can only take a view on that if you know what’s happening in the company accounts and in the decisions the chief exec is making.

If the boss has lost the plot in your eyes, maybe a bout of volatility is warranted and it might be time for you to reconsider your position. If everything looks good, it might be the rest of the market or sector is dragging your stock down with the crowd. That might give you the confidence to stay put or even take advantage of a market mispricing.

In this sense, doing your homework allows you to approach volatility with a much more rational mind.

This is as much about preparing yourself as about preparing your portfolio. Make sure you know that volatility is the price we pay for the hopeful long-term outperformance of stocks over cash - it’s going to happen.

To help prepare even further, it can be a useful exercise to imagine a stock in your portfolio is going through a rough patch. In your mind, what is likely to have caused this imaginary volatile streak? How likely is it and is it a major concern? Conducting a pre-mortem like this can help you stay calm if the real version arises and helps highlight any weak points in your portfolio.

It may sound simplistic but don’t underestimate the power of diversification in managing volatility. If you make sure you hold a range of assets with uncorrelated influences, they should be able to pass the baton back and forth, picking up the slack for each other when waters get choppy. The effect should be to dampen the overall volatility levels in your portfolio and give your money the chance to grow in a range of market conditions.

It’s amazing how many people set up their portfolio to tackle difficult periods, then change the whole thing when that exact eventuality comes. We are primed to think we need to perform some sort of action when the market starts swinging but, quite often, it’s inaction that serves us best. As UK fund manager Terry Smith says, “Don’t just do something, sit there.”

The reason it’s not a great idea to jump in when you’re worried or scared is that it is exactly those emotions that are running the show. Nobel Prize winner Daniel Kahneman talks about the two brains we have when we encounter a pressurised situation. The first is instinctive, protective and rash. The second is methodical, thoughtful and logical. While the former is the most useful if we see a bus flying towards us, it’s the latter we need in investing. If you don’t have a good reason to act quickly, pause and reflect - it’s difficult but could save you from yourself.

Remember, you’re focusing on the long term, so if you concentrate on the underlying business, the short-term ups and downs in the share price shouldn’t matter. It’s hard to ignore the charts changing between red and green, and shooting off in different directions but they actually tell you very little about the company underneath it all.

That’s why it’s not a good idea to get buoyed by a short-term gain or upset by a downward blip. What you’re seeing is other investors’ reactions and not what the business is doing. It can be an overreaction in both directions and the last thing you want is to take the market at face value without any substance behind it. Stay as level-headed as possible and remember, that spike means nothing if you have no intention of selling up just yet.

Most tips so far have been about taking your emotional self away from the buy and sell buttons. That’s because, as Kahneman shows us, we’re pretty unreliable at making good choices when we’re under pressure.

What if we were able to use volatility to our advantage though? Keeping a small amount of cash in your portfolio, specifically to pounce on drops, can be a useful strategy. You get a cheaper price for an asset you already liked and it may even bring down your average price paid. The danger is this cash buffer is too big or sits there for too long doing nothing. Only you will know how much is reasonable but the important point is that it shouldn’t detract from performance elsewhere in your portfolio and should pull its weight eventually, just like the rest of your holdings.

If opportunism isn’t your thing, have a think about dripfeeding your money into the market at regular intervals. You’ll naturally catch the highs and lows but the long-term effect should be to smooth out the price you pay for an investment and, crucially, it takes the decision-making out of it all.

Important information

When you invest your capital is at risk. Past performance is not a reliable guide to future gains. Your investments and the income you receive from them may go down as well as up so you may get back less than you invest.

This article is intended for educational purposes only. Make sure to do your own research on what investments are right for you before investing or consider seeking expert advice.