What Investors Need to Remember About Market Volatility

(Bloomberg Opinion) -- It's natural for investors to be nervous during periods of heightened global and market uncertainty such as what we're currently experiencing.

Although one's gut reaction may be to sell everything and avoid further losses, acting on that impulse will very likely hurt you financially over the long term. The key to managing volatility starts with getting clear about why you are investing and what your time horizons are.

Investors with short-term goals — such as buying a house in the next five years or paying college tuition — are generally advised against putting their funds in the stock market, since there might not be enough time for a portfolio to recover after a market sell-off. If you do have a significant chunk of your short-term savings in equities, you should be reviewing them with a view towards minimizing risk.

For younger investors with longer-term objectives, periods of market weakness represent an opportunity. Those under 40 saving for their retirements, for example, will very likely invest more in the future than they have done to date. A bout of market weakness is therefore a chance to invest more at lower levels.

This doesn't mean swing the bat and plunge all your spare cash into the market at the slightest setback. Rather, you should heed the advice to make regular contributions to tax-advantaged, low cost, diversified funds. That way you can benefit from the twin wonders of finance: dollar-cost averaging and compounding returns.

Investing a regular cash sum each month will purchase more units of a given fund when the market is weak and fewer when it is strong. The net effect is known as dollar-cost averaging, and it can significantly reduce your average purchase cost. Compounding is another powerful wealth-building force. Reinvesting a 7% nominal return each year will see the principal investment double in 10 years, and the effect only gets more dramatic over longer investment horizons.

Where things get a little more interesting, and less intuitive, is around how older investors should react to market volatility. They are likely to have accumulated more capital, so the opportunity to invest at lower levels is offset by the risk of a loss to their existing wealth.

To help solve this particular conundrum, many investors turn to rules of thumb such as the well known “4% rule.” This involves withdrawing 4% of your fund in the first year of retirement, and then increasing the annual withdrawal by the rate of inflation each subsequent year. Based on historical studies, this should ensure that you don't run out of money over a 30-year retirement.

The 4% rule assumes that your funds are split equally between equities and Treasuries. Thus, if you have fewer equities than the rule suggests, a dip in the market might be a good time to top up.

If you have more than 50%, that's not necessarily a problem. Studies seem to suggest that the higher the allocation to equities, the lower the probability of you outliving your savings. Nevertheless, if the volatility is causing you sleepless nights, cutting back toward 50% might help you to rest a little easier.

However, past performance does not guarantee future returns. Bond yields are substantially lower than when the 4% rule was first conceived (looking back from 1976) and equity valuations are significantly higher. This means that an initial safe rate of withdrawal is most likely lower than 4% with some studies recommending a figure as low as 2.5%.

This risk has been underlined by the fact that both bonds and equities sold off heavily as 2021's inflation spike continued into 2022. Bonds only regained an element of composure after Russia invaded Ukraine, displacing inflation as the market's major preoccupation.

Long-term investors of any generation need to be mindful of the benefits of an internationally diversified portfolio. Individual markets are always susceptible to idiosyncratic risk. Those invested in either Russia or Ukraine will need no reminding. Even the mighty Amazon crashed 90% in the 2001 tech wreck. Many of its peers never recovered. Japan's Nikkei 225 index famously lost 80% of its value between 1989 and 2008, and today it remains 30% below its peak.

The requirement for diversification has been underlined by the current rotation, not just out of technology stocks but from growth stocks in general. The upshot is that more stable, dare I say boring, companies have comfortably outperformed so far this year. Indeed, the dear old FTSE-100, replete with venerable cash-generating blue-chips but offering little novelty to investors, has outperformed the S&P 500 by almost 11 percentage points so far this year. And we're barely into March.

This underlines the importance of keeping yourself diversified, both internationally and across sectors, even if, on occasion, that means having some money in unfashionable markets such as the U.K.

What we're left with is a clear message to longer-term investors of all generations not to lose faith in equities. For younger cohorts, market setbacks are unambiguous opportunities, helped by the powerful forces of dollar-cost averaging and compounding. But their parents and grandparents can also take advantage of market weakness by topping up if they hold insufficient equity risk to minimize the likelihood of them outliving their capital or are inadequately diversified.

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