Implementing the market volatility survival plan

Last week’s market gyrations were extreme and seemingly out of proportion to the apparent triggers - a US Federal Reserve (Fed) behind the curve of a slowing US economy, modestly higher interest rates in Japan and worries that artificial intelligence (AI) may deliver less than hoped.

But perhaps the real aberration was not the biggest fall in the Nikkei since the 1987 crash, nor the largest rebound in the Japanese market since the financial crisis, but the nearly two years beforehand without so much as a 3 per cent daily move either way for the S&P500. What seems likely is that this period of relative calm is over. Volatility is back.

Against a deeply worrying backdrop in the Middle East and Ukraine, and ahead of what is certain to be an acrimonious and close-run Presidential election, events in the next few weeks will keep investors on edge. The annual Jackson Hole summit and Nvidia’s results at the end of the month are prominent. So too will be the next US payroll and inflation data, and the Fed’s rate-setting meeting in September.

I was on holiday when the balloon went up last Monday - a good place to be when these things happen. It’s easier to think clearly by the pool than in front of a screen. And, as is often the case, by the time I came home at the end of the week, things looked more settled. My enforced zen made me wonder how I might bottle that Mallorcan calm to better handle the next bout of market turbulence.

There are three elements to my volatility survival plan. The first is understanding. The second is preparation. The third is clear-thinking and discipline.

There are several aspects to understanding. First, knowing how markets operate over time provides useful and calming context. Especially after a long period of steadily rising prices, it is easy to forget that around half the time markets are 10per cent or more below their most recent peak. Corrections are part and parcel of the investing experience. They are the price we pay for the long-term outperformance of shares. The ten biggest falls in the FTSE 100 since 2000 led to subsequent three-year returns of between 6per cent and 60per cent.

Second, there is a personal aspect to understanding. How much market volatility can I really tolerate? Anyone can be an investor when the market is going up. But ask yourself how you will feel when your portfolio is worth 20 per cent less than it was a few weeks or months ago. And be honest. Will you really be able to sit out the correction and wait for better times? Stock market investing is not for everyone.

Third, understand what’s in your portfolio. Two weeks ago, I signed off by suggesting that if you didn’t know how exposed you were to AI, now would be a good time to find out. The same could have been said of your exposure to Japan last week. The balance of your portfolio can be disguised within global funds, especially index trackers. Some investment platforms have so-called X-ray tools, which can be helpful.

Preparation has a few strands too. The first is diversification. Last week, we saw the benefit of holding a mixture of shares and bonds. While stock markets were tumbling, bonds went the other way. A balance of assets in a portfolio really does provide a smoother ride. Geographical diversification matters, too. There was a lot about last week’s market action that was Japan-specific. It was clear early on Monday morning that this was not a systemic, global issue. European markets fell but by significantly less than Tokyo.

The importance of dry powder was underscored last week too. You would have had to be very quick, and gutsy, to put cash to work last Monday. But without liquidity you cannot take advantage of the market’s irrationality. Mr Market does sometimes serve up some amazing bargains. You need some cash in your back pocket to benefit.

The third part of the plan, clear-thinking and discipline, is the hardest to implement in the heat of battle. The trick, as ever with investing, is to take the emotion out of your decisions. And the best way to do this is to follow a pre-set plan. I recommend writing down a set of questions now, when nothing’s happening, and pinning it next to your screen. No one makes good decisions when they are scared.

The first question to ask is what has really changed. I don’t think anything really had last week. If there is a recession in the US, it will likely be short and shallow. Earnings growth didn’t just continue in the second quarter, it accelerated. Unemployment is edging higher but remains low.

Second, it’s worth considering how significant, as opposed to merely dramatic, the market action is? For me, the key moment last Monday was when European markets opened just a couple of percentage points lower. The fall in the Japanese market was shocking, but there was less to it than seemed possible as I watched the dawn break in the Serra de Tramuntana.

Third, what is the context? The big fall in the Japanese market is less surprising when you consider that the Nikkei index had risen by about 65per cent between the start of 2023 and the middle of July. Many investors had ramped up their bets with borrowed money. If portfolios were going to be de-risked anywhere, it was likely to be in Tokyo.

A final key question when deciding how to respond to a big market move is what you will do next. What will you do with the money you take off the table? And what would the circumstances be for you to get back into the market? If you don’t have good answers to these questions, the best course of action might be to do nothing. And have another swim.

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Please note that the views expressed in this article are my own.