The important role of diversification and focusing on the 'escalator, not the yo-yo'

In the early months of 2020, the global coronavirus outbreak led to a sudden market meltdown - only to be followed by a surprisingly quick recovery by the summer. Not long after, in 2022, equity markets around the world entered bear market territory, before rallying again in 2023.

And it’s perhaps not surprising that with geo-political tensions in the Middle East and Ukraine, and recent events in South Korea and France acting as a catalyst for political uncertainty, many investors will have volatility on their minds.

The reality however is that, historically, market volatility is normal. Periods of high volatility can extend for multiple quarters or even years, and market swings only seem surprising if we’ve had a longer-than-usual period of relative calm or there has been a prolonged bull run or bear market.

The importance of 'Time in the Market' versus 'Timing the Market'

Part of planning for volatility is being prepared psychologically and understanding that downturns as well as upswings are part of the market cycle. And although future market trends cannot be predicted, it’s important to remember that every market correction or bear market has historically always been followed by a recovery.

If volatility causes you worry about achieving your long-term goals, it can be helpful to visualise the following analogy. Picture a person riding up an escalator while playing with a yo-yo. The yo-yo represents the volatility of a stock market index – on an hourly, daily, and weekly basis, it will always go up and down - but importantly, in the wider context, the long-term trend and direction of travel is consistently upwards.

‘Focus on the escalator rather than the yo-yo’

Also important psychologically is to tune out media noise. When you hear messages of doom in falling markets, you’d never know volatility is normal and expected. The news media need stories, but you don’t need the anxiety.

Dampening the effect of volatility

The volatility you experience in your portfolio is a milder version of what’s happening overall in the markets. Your portfolio’s asset allocation dampens volatility as the fixed-income component acts as a ballast, helping to smooth out returns. Also, diversification within each asset class reduces volatility, while minimizing risk.

Investors who want to make their portfolio less volatile can choose a risk rated investment strategy with reduced exposure to equities and market indices and a greater allocation to fixed income [government and corporate bonds, cash and cash equivalents].

Even when you know volatility is expected, extreme market swings can create the sense that “this time it’s different.” When a bear market is especially long and bleak, it’s understandable that anxiety can take hold with investors believing that this time the markets won’t rebound, and their portfolio will never recover their former value.

And whilst volatility and equity bear markets make all the usual challenges of being a long-term investor that much more difficult, it’s at times like these that it’s valuable to remind oneself that it’s ’time in the market’, rather than ‘timing the market’ that counts.

'Timing the market' by selling at the top and buying at the bottom sounds straightforward in principle, but in reality is virtually impossible. Ironically, the best performing days of the market often occur in close proximity to the worst, so trying to beat the market by taking short-term positions to avoid losses can often mean missing out on the days in which the market grew the most. Using the FTSE 100 again as an indicative index to illustrate this point, an investment of £100,000 made in January 2000 and left invested until January 2024 would have delivered a return of £263,152. Missing out on just the 10 best performing days during that 24 year period would result in a return of just £200,493, effectively costing the investor 63% on their overall return*.

The role of diversification in long-term investing

Diversification is essential for long-term investors aiming to maximize returns while managing risk. By spreading investments across various assets, investors can protect their portfolios from significant losses associated with the poor performance of any single investment.

Risk Mitigation: Different asset classes and sectors often perform differently under varying economic conditions. Diversification reduces the impact of poor performance in any one area, providing a buffer against volatility and reducing overall portfolio risk.

Steady Returns: A well-diversified portfolio is more likely to achieve stable returns over time. While some investments may underperform, others may exceed expectations, balancing out overall performance.

Opportunities for Growth: Diversification allows investors to tap into different growth opportunities across sectors and regions. This not only spreads risk but also opens up multiple avenues for potential gains.

The key is to ensure you hold a well-diversified portfolio with asset allocations that reflect your risk profile. In this way you can mitigate the impact of market volatility by not being too exposed to any asset class and remain in an ideal position to benefit from recovery, in whatever form it takes.

Our core philosophy

Our core philosophy at Forth Capital is to provide each of our clients with an optimal investment solution; a bespoke goal-based financial plan tailored to their individual requirements, combined with access to a range of straightforward, transparent, award-winning investment strategies, designed in partnership with Morningstar [the world’s largest funds analytics company], to help them achieve those goals.

In 2016 we partnered with Morningstar to draw on their world-leading investment, asset-allocation, and risk profiling research, delivered by 270 analysts worldwide. The 'Next Generation Investment Strategies' provide exposure to a broad range of asset classes, delivering strategic diversification, aligned to each client's risk profile.

If you‘re not currently a Forth Capital client and are anxious about your current portfolio, please get in touch.

Together, we can look at your risk profile and your portfolio, analyse your current investment strategy to determine whether it’s right for you, and confirm whether you’re on track to meet your goals.

* Source: Columbia Threadneedle Investments FTSE 100 Total Return (TR) Index and the impact of missing the 10 best % days on £100,000 invested.

This communication is for information purposes only and does not constitute financial, legal, or tax advice. To receive advice on financial planning, wealth management and pension solutions, please schedule a meeting with one of our Financial Advisors and Pension Specialists.