In this, the first of 3 posts on the subject matter of how to insulate your portfolio against volatility, to create a strategy you can feel comfortable staying invested in through challenging markets - we focus on a simple philosophical mindset shift that will first be required.
‘Keep calm and carry on’ is a glib cliché that resonated as a T-shirt for two minutes. For those more sensitive to stress, just saying it doesn’t make it happen, of course. It’s the same with your portfolio. Everyone is told ad nauseum to ‘stay invested’ and that what counts is ‘time in market, not timing market’. This make sense – we know the best days tend to follow the worst - but how is this done? How do you stay invested during economic uncertainty and keep calm?
To achieve this, investors want to feel a degree of control. Imagine, for a second, you are a top-level sports coach – do you pick a player who gives you 10/10 one week and then 2/10 the next or do you go with the one who is more likely to give you a 7/10 both weeks. The first option is win or bust but the second offers greater security and a better chance of more consistent victories.
The punchline: Sacrifice top-end returns for greater consistency
From a psychological perspective, it doesn’t matter if you shoot the lights out with a 20% annual return if a 2020-type downturn means you don’t participate in the next three years. By setting the parameters of your highs and lows, it helps control emotions, and reduces the likelihood of you making risky decisions by selling up or chasing outsized returns. According to loss aversion theory, people feel the downside twice as hard as the upside, so 20% returns psychologically wash out only 10% of losses. Call it survival instinct.
Therefore, while investors don’t like it when they miss out on 5% of the upside, being down 5% more than the market is much harder for them to accept. A portfolio strategy that looks a little less attractive on the way up but (comparatively) looks much better on the way down is easier for investors to swallow.
Coming up next in post #2
In our next post, we will look at a very simple and easy to execute strategy that individual DIY investors can implement to help achieve this type of portfolio experience.