The influence of high volatility on retirement investors and their portfolios
Given their longer-term horizons, retirement investors would seem to have the greatest motivation to resist short-term pressures and stick to a predetermined portfolio allocation amid event-driven market volatility. A recent Fidelity report on the investment behavior of participants in workplace retirement savings plans shows that most people did stay on track during the peak 2008–09 period of financial market instability. However, it also showed that there were costly implications for the fraction of people who did tinker with their portfolios based on the market turmoil.
Among the key findings: On average, participants who kept contributing to their retirement plans throughout the 18-month period (October 2008–March 2010) had higher account balances than those who stopped contributing;Participants who maintained a portion of their retirement plan asset in equities throughout the entire period ended up with higher account balances than those who reduced their equity exposure amid the peak period of market distress . Thus, retirement investors who kept contributing to their plan and who maintained some exposure to equities throughout the period were better off throughout the market's 18-month bust-boom period than those who moved in and out of the market in an attempt to avoid losses.
Retirement investors who kept exposure to equities amid the peak of the global financial crisis ended up with higher account balances on average than those who reduced their equity exposure to 0%.
Managing your portfolio as volatility (and fear) escalates
As the examples in this article illustrate, the influence of loss aversion can cause investors to liquidate their holdings in an asset class during periods of high volatility. Investors who let their emotions guide decision making during these periods of market turmoil tend to reduce their assets at the worst possible time and when it is the most costly to them—near a market bottom. Acknowledging our human propensity to allow fears of loss and other emotions to drive our investment decisions is the first step toward finding a preventive method to keep you from tearing apart a well-constructed portfolio the next time it appears the financial markets are imploding.
Periods of heightened market volatility offer a stress test of sorts for our risk tolerance. How did you respond to your portfolio's performance during the recent spike in volatility? Were you more or less risk tolerant than you had originally thought when you conceived your portfolio mix? Psychologists have documented that our species is particularly bad at predicting how we will react under difficult circumstances. While we tend to be optimists, believing we will make the right decisions under duress, in reality many of us don't always respond as we forecast.
Due to our inherent human biases, putting predetermined measures in place may be critical to keeping ourselves from being consumed by our emotions during periods of high volatility. While the stock market has demonstrated an ability to persevere through many tumultuous events, one thing you can count on is that new storms are bound to blow in and create instability. Simple steps to prepare yourself for the next threatening market storm include studying your own history of reaction during periods of high volatility, reevaluating your portfolio strategy, and ensuring your asset allocations provide a level of diversification that suits your risk tolerance. During periods of short-term volatility, such long-term discipline can provide a healthy counterweight against behavioral biases that may conspire to throw your investment strategy off track.
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