Nine investment mistakes to avoid in volatile markets

As I write this story, global equities are experiencing some of the steepest declines in market history.  Many investors are reeling from losses and extreme daily volatility.

In this environment, avoiding mistakes can be far more valuable than looking for the upside. So what should you focus on in this time of turmoil?

1. Do not underestimate your cash flow needs

As many investors have learned to their horror, risk profile and timeframe matter little if you have expenses that must be met and need to sell assets at their lows.

Famed British economist John Maynard Keynes is attributed with the saying, “the market can stay irrational a lot longer than one can remain solvent”, a reminder that markets can fall, sharply, at very inconvenient times.

Only invest funds you can afford to keep in the market for the long term and ensure you have a healthy cash buffer to meet expenses.

For retirees in pension phase, this can mean up to three years’ expenses. For younger people with a secure income, it could be three months. For those with a mortgage or other significant liabilities, the cash buffer may need to be larger.

2. Do not ignore timeframe guidelines

Severe market falls can dramatically wipe out years of gains; recoveries can be sharp and thrilling. It is critical you have sufficient time in the market to take advantage of the latter, particularly if your portfolio has been subject to the former.

The general advice for investing in shares is a minimum timeframe of five to seven years, but many suggest 10 or more.

The current downturn comes at the end of the longest bull run in market history, from a low in March 2009 to a peak in February 2020. The peak prior to February 2020 was September 2007 and a cycle of this length is the exception rather than the rule. Investing is a long-term game.

3. Overestimating risk tolerance

Many believe we can tolerate a 20 per cent drop in the value of our assets – until it happens. Having been (relatively) young during the GFC, the daily calls and emails from terrified investors were an experience I hope are never repeated.

Retirees who had no opportunity to replenish their capital had been invested in growth and high-growth options without any real understanding of how much volatility their portfolios could experience.

Each day of falls on global sharemarkets caused further panic and many ended up selling at the lows as they simply could not take the anxiety any more.

4. Do not overestimate the benefits of diversification

Diversification is often sold as a panacea for risk and volatility concerns. As the GFC taught us, in an interconnected world many assets are more highly correlated than the textbooks would suggest. Try to ensure your portfolio is diversified across different asset classes, and within them, but remember that all assets – with the exception of cash – carry some risk.

5. Do not be afraid to take profits

After years of strong returns, investors can be lulled into a false sense of security, believing their shares (or house prices, for that matter) will always go up. Knowing this is not the case, it can make sense to take profits after particularly good years, using the proceeds to diversify into other asset classes or build up your cash buffer.

Obviously, this is not terribly useful advice right now, but worth remembering for future cycles.

6. Approach timing the market with caution

Highly volatile markets may encourage the risk-averse to flee, but they can also bring out the hidden speculator in a more confident investor.

Huge daily swings can offer amazing short-term profits for those who act quickly, but with so much uncertainty the average investor may wish to take a more cautious, longer-term approach.

Trying to catch a falling knife is a spectacular trick when executed to perfection – or a bloody mess.

On the upside, market turnarounds usually occur six months before the economic data turns broadly positive, and missing the first few days of the turn can result in missing a substantial proportion of the gains.

7. Be wary of the dividend trap

The generous fully franked dividends paid by many large cap-Australian companies have been hugely tempting for Mum and Dad investors, particularly those in pension phase. The grossed-up income has surpassed anything traditional income investments could offer, leading many investors to ignore the fundamentals and prospects of the company in which they are investing.

The loss of capital from shares in volatile markets may not less relevant where dividends are maintained, but headwinds for these companies can result in substantial cuts to dividends, causing investors to suffer a double loss.

Although yield is imperative, do not lose sight of the prospects for the company that pays your dividend.

8. Do not forget the good times

Markets are naturally forward looking and until recently seemed to be perennially optimistic. As share prices plummet, it is easy to forget the good times or believe they never happened.

For most investors, however, gains that have subsequently been erased were not illusory; in many cases, investors have taken profits throughout the good times.

Perhaps more importantly, investors have received excellent dividends over the past decade. Even with the market climbing to its highs, the yield on the ASX 200 was about 4.4 per cent before franking throughout 2019, substantially higher than the yield on other asset classes such as cash, fixed income and property.

The dividends received over the decade have paid for groceries, holidays and other expenses, or been reinvested to create future wealth.

We know from research by behavioural economists that losses hurt roughly twice as much as winning feels good[1]; try not to forget that investing in the sharemarket has probably generated real value for most investors over the past decade.

[1] See Thinking, Fast and Slow by Daniel Kahneman for a good guide to our irrational behaviours.

9. Do not give up on investing

Often the hardest part of investing is making the decision to get started – and to stay the course when things get tough. It is likely that the sharp and painful falls on markets will scare many investors away from shares for months or years, or possibly forever.

These investors will lose the opportunity to participate in the inevitable market rebound, never receive the benefit of dividends and franking, and sit on the sidelines when Australian companies return to growth and profitability.

Be safe, but be sure not to give up on investing altogether.