Handling the tough psychology of volatile markets

One of the most difficult aspects of investing is dealing with the psychological fallout of market volatility. Ordinary, or sometimes out-of-the-ordinary, market swings can make the value of your investments fluctuate dramatically. This can make you feel that you’re actually making or losing great chunks of money daily — sometimes even hour-to-hour in a very volatile market — and stir up the accompanying emotions of euphoria or depression.

As if the mood swings weren’t bad enough, volatile markets can produce all kinds of potentially harmful investor behaviour. These include jumping in and out of investments, ignoring your investments entirely or increasing your market exposure to recuperate losses. All these reactions may bring some relief in the short term, but have the potential to damage longer-term portfolio performance. Sometimes, they don’t even work in the short term.

The wisdom and maturity needed to see past volatile market swings can be developed with experience. However, to get to that point without giving up, a well-developed trading strategy and the willingness to think through possible responses to different market turns can help. For anyone who wants to make sure they’re maintaining discipline, and especially for newer investors, a well-thought-out trading plan can be a lifesaver.

Let’s look at some of the elements of a good investment or trading plan. 

• The plan is created, critiqued and refined before money is committed to the markets. 
• It acknowledges time horizon, which can differ for different “baskets” of money under consideration. A particular amount of money might be tagged for retirement, another for short-term trading ideas, a portion for an emergency fund and so on. Investments allocated to a longer-term goal, such as retirement, can withstand more volatility because the investment has time to regain value. Shorter-term investments don’t have this luxury.
• The plan could consider and implement an acceptable loss percentage: “I’m willing to lose this much before I pull the plug on this particular investment”. This kind of thinking gets you used to the idea that an investment can move against your forecast. It makes sense to think through what evidence you’ll need to convince yourself that you’re wrong, at least in the short term, and what action you plan to take if that happens.

This can be especially useful in periods of market strength, when euphoria can prevent you from taking profit. It also helps you avoid being blindsided if the market moves against you. You can be ready to cut your losses if that’s part of the plan, or sit things out. Either way, if you’ve mentally walked down that road, the road won’t seem so scary and you lessen the likelihood that you’ll act impulsively.

• Stay on top of investment news, but put the news in context. How frequently you tune in will depend on both your investing time horizon and your reaction to news stories. Markets often anticipate news events and factor the outcome into asset prices before an event actually takes place. The famous investing maxim “buy on rumour and sell on news” describes how an asset can move up or down in price in anticipation of a positive or negative event — but decline or rise when the event actually takes place, leaving some investors scratching their heads.
• Acknowledge that “black swan” events can occur. These are defined as events that come as a surprise, have a major effect, and are often inappropriately rationalized after the fact with the benefit of hindsight. Black swan events happen without warning; their unpredictability is exactly what makes them black swans. Even someone with near-perfect investment insight can’t foresee events such as random terrorist attacks, power outages that shut down trading exchanges and other “acts of God”. It makes sense to acknowledge the possibility of future black swan events when creating your investing strategy, especially if you’re more short-term oriented.

A trading plan lets you mentally rehearse different market scenarios and have an action plan ready — a smart tool in both volatile and quiet markets. A plan to do nothing under certain circumstances can generate and protect profits just as much as specific action steps. The plan becomes a way to blunt the effects of media sensationalism, the well-meaning but possibly detrimental opinions of friends and colleagues and your own emotional responses to market events.