How can investors help navigate high market volatility? Prepare for bear markets before they even begin
Any financial adviser will likely tell you that their job is considerably easier in a bull market. The phrase “a rising tide lifts all boats” comes to mind. Clients typically have fewer questions about the composition of their portfolios when returns are greater. And, up until recently, the markets of the past decade have been keeping questions to a minimum.
The same cannot be said during bear markets. If portfolio values have rapid, meaningful declines, investors often fear those trends will continue. This can lead them to panic and react in ways that compromise the long-term integrity of their portfolios.
This isn’t a surprise. Ample research done since 1979’s Prospect Theory paper (by Daniel Kahneman and Amos Tversky) suggests investors feel the pain of losses about twice as much as the pleasure from gains. And, of course, we do. A healthy fear of deadly lions provides a much greater evolutionary benefit than a healthy enjoyment of playing with friendly kittens.
As we enter the second half of 2022, many believe we are in the early stages of a bear market and a global recession. It is almost certain that investors will now more heavily scrutinize their portfolios to try to mitigate the economic storm. So how can investors help navigate high market volatility?
OK, I admit it’s a trick question, because the best answer is this: prepare for bear markets before they even begin. A key step in this is asset allocation.
An optimal portfolio is well-diversified and built with future bear markets already assumed. Bear markets are a regular part of economic cycles. Financial advisers should be making this clear to clients before they occur, not reacting after the fact.
From a portfolio level, this means that, within the parameters of an individual investor’s situation and goals, maximizing the expected risk-adjusted returns while keeping volatility to the absolute minimum possible. This is especially important for retirees, or those nearing retirement, who cannot risk large dips in their portfolios.
One of the best means of preserving wealth during market instability is exposure to a highly diverse asset mix. As a whole, financial markets tend to grow over time, though not every asset class experiences equal gains, consistency or equal volatility. Having exposure to many asset types with unique characteristics, that do not move in tandem with one another, helps investors participate in the overall growth trend.
Most investors likely know this mainly as their “mix of stocks and bonds.” But, of course, with current trends pushing the values of both those asset classes simultaneously downward, the incomplete nature of the stock-and-bond portfolio becomes more evident.
In my opinion, and likely the opinions of large institutional investment managers (if their chosen asset mixes are any indication), proper asset allocation should include a healthy blend of private and public assets. It should also include hard assets such as real estate.
At Nicola Wealth, we still participate in public markets, but we complement them with other non-correlated asset classes. For example, while there is certainly a role for public equities to play, they currently make up only about 22 per cent of the Nicola Core portfolio versus about 60 per cent in most traditional balanced portfolios, which reduces volatility, especially noticeable during bear markets such as the current one we find ourselves in.
Asset allocation also speaks to a broader guiding principle of adhering to strict investment criteria for clients. Portfolios need to be built in a holistic context. Each asset added should be qualitatively accretive to the overall mix, not simply following returns or trends.
For example, we do not typically include speculative or unregulated investments in our portfolio construction. After 2017, we avoided the cannabis market boom and subsequent crash. We also do not invest in cryptocurrencies since the unregulated nature of the crypto market has already burned many investors to the tune of billions of dollars.
All in all, 2022 has certainly been a painful time for many investors, but some investors’ pain has been limited to “my portfolio hasn’t grown as much as I expected,” and not, “my portfolio has lost a fifth of its value!” The difference starts with a truly diversified portfolio.
Chris Warner, FCSI CIM CFP PFP, is a wealth adviser at Nicola Wealth.