A few fundamentals can help investors reduce the downside effects of market upheaval.
Stock performance charts clearly illustrate that 2020 had its ups and downs. Economic conditions began the year on an encouraging path until the spread of COVID-19 suddenly catapulted them into an unsettling phase. The effects of the initial measures to control the pandemic rippled through financial markets for several weeks afterward. And while this first shock was followed by a surprisingly swift recovery that managed to continue into the latter half of the year, the impact of this activity on the economy may be felt for some time to come.
Regardless of the causes and effects of market fluctuations, experts continue to emphasize the importance of staying invested, rebalancing portfolios and taking advantage of opportunities during volatile times. Doing so can help investors move forward with confidence instead of fear while they anticipate the return of more normal conditions.
Don’t walk away
Emotions can run high during a crisis, which can influence how people react. A sudden market sell-off can trigger highly charged emotions. Investors may experience the “fight or flight” compulsion to just do something, without fully considering the risks. In the heat of the moment, an investor might transfer everything into cash and flee the markets altogether. This reaction is understandable, given that dramatic downturns like the one in early 2020 are rare. But many people may not realize that stepping away from their investments could end up costing them more than if they had simply stayed invested. When markets recover, which can happen quickly, there may be little time to capitalize on the turnaround.
Since no one likes missing an opportunity, remaining actively invested for the long term can be an important guiding principle. Staying invested allows investors to employ some other fundamental principles and emerge from the rough patch prepared for better days ahead.
Invest on a schedule
Dollar-cost averaging (DCA), the act of making regular investment contributions regardless of the market’s status, is known to outperform the inherent risk of trying to predict market upswings and missing out on the market’s best days. With regular contributions, there’s no risk of missing the boat when markets rebound, and no way of knowing when the big gains will occur.
A DCA strategy lowers the average price per unit paid over a given period while creating the potential for higher capital appreciation. Regular investments can help investors look beyond market turbulence. Sticking to a schedule can eliminate the urge to monitor markets for signs of a strategic buying opportunity, and instead generate more consistent returns based on an average investment price.
For example, buying $100 worth of units of the same investment every week means that the cost of each unit will vary from week to week. Lower prices enable the purchase of more units; higher prices mean fewer units can be purchased. On average, more units can be bought at a lower price than would be likely at any individual moment. Having more units that appreciate over time will ultimately lead to more return on the investment.
Most contribution plans offer the flexibility to customize how much to purchase, how often purchases can occur and how they can be applied to a range of investment options.
Rebalance to reap rewards
A willingness to adapt to changing market conditions is key to helping investors avert any tendency to think of themselves as victims of volatility. And while dollar-cost averaging will help keep investment costs lower with regular purchases, another step can help portfolios avoid being overly affected by market fluctuations.
Regularly rebalancing the allocation of funds in an investment portfolio can provide protection when markets move into more unsettled territory. A diversified portfolio consisting of 60 per cent equities and 40 per cent fixed income has historically performed slightly better in market sell-offs than portfolios invested only in equities. The standard 60/40 mix may have some difficulty keeping pace with a 100 per cent equity strategy when stock markets begin to outperform. However, when equity markets decline, a balanced portfolio will inherently become overweight in fixed income and suffer less downside than one that consists entirely of equities. By selling some of those assets and buying depressed equity to rebalance, the portfolio takes advantage of opportunities.
“The data we’ve collected over the past four decades illustrates that rebalancing your portfolio as often as quarterly, or at the very least, annually, is a solid strategy to cushion the impact of volatile economic conditions,” says Manulife Investment Management’s Chief Investment Strategist, Philip Petursson. “This way, investors can reduce their equity risk, add some protection against the downside, and take advantage of lower equity costs that are well positioned for growth. When you compare a balanced portfolio to 100 per cent equities, you see less downside risk, but also see similar upside performance over extended periods of time.”
The historical performance of a balanced portfolio compared to one that consists of 100 per cent equities is illustrated in the following charts.
Investment growth of $10,000 – equity portfolio vs. balanced portfolio (since 1976)
This chart shows the close alignment of the investment growth of $10,000 in an equity portfolio vs. a balanced portfolio (since 1976).
Source: Manulife Investment Management, Bloomberg, March 31, 2020. [Past performance is not a guarantee of future performance. The index is unmanaged and cannot be purchased directly by investors. The rate of return shown is used only to illustrate the effects of the compound growth rate and is not intended to reflect future values of the investment fund or returns on investment in the investment fund.
Comparison of different approaches to staying invested and rebalancing (since 2007)
This chart shows that a balanced portfolio offers better protection during a down market, while the quarterly rebalance allows for the purchase of equities at a discounted rate.
Source: Manulife Investment Management, Bloomberg March 31, 2020. Past performance is not a guarantee of future performance. The index is unmanaged and cannot be purchased directly by investors. The rate of return shown is used only to illustrate the effects of the compound growth rate and is not intended to reflect future values of the investment fund or returns on investment in the investment fund.
“Statistics show that investors can seize the advantages of a downward market sell-off by shifting their asset allocation to the lower-valued asset class, which, in effect, is dollar-cost averaging without having to commit new capital,” adds Petursson. “If you stick with the fundamentals and set your portfolio back to its intended target weights, it will reap the benefit of underpriced equity when markets begin to rebound.”
The value of advice that comes with a strong relationship between advisors and clients is important at any time, but even more so during times of turbulence. When markets wobble, it’s natural for individual investors to become nervous and concerned, so the message needs to be clearer than ever: stay the course, focus on your goals and rebalance as necessary.
While there are reasons to expect more economic unsettledness with the ongoing disruption caused by COVID-19, much has been learned about managing the virus and its effects on the economy. As more information surfaces and public health strategies account for that knowledge, a more optimistic view of market activity in 2021 appears prudent.
According to Philip Petursson, “In our base case, we’re plotting in a recovery in earnings for 2021 that’s going to get us very close to where we were in 2019. Our assumption is that 2021 is going to be what 2020 would have been if we didn’t have a pandemic.”
Yet, as witnessed this year, surprises can and do happen. Investors who are committed to following the fundamentals, regardless of the current situation, will be better prepared to absorb future market shocks.
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