Investing Through Times of Market Uncertainty
In 2002, Secretary of Defense Donald Rumsfeld famously said, “…there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say, we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.”
While Rumsfeld was speaking about the various dangers in “the war on terror” he could have also been describing the investor experience when markets appear more uncertain than usual.
Whether geopolitical or economic in nature, unknown factors from major events – such as the 9/11 terrorist attacks and the Federal Reserve’s stimulus taper – tend to rattle markets and investor confidence. Understandably, humans find comfort in consistency, which is why many investors abandon their portfolios when markets are volatile.
If investors want to try to limit volatility in their portfolios, they should diversify across different asset classes and rebalance periodically to set and maintain their desired level of risk. Although these strategies do not provide any more clarity on future market returns, they help an investor control their risk exposure.
Managing volatility and risk
High volatility is a common in times of market uncertainty. The market fluctuates as anxious investors try to time the market by pulling their money out or jumping into assets they think are safe at the time.
When markets first reopened six days after 9/11, as rubble still burned blocks from Wall Street, the Dow Jones ended the day down 684 points. In 2013, markets vacillated between sharp drops and record highs after vague comments from Federal Reserve chairman Ben Bernanke on whether or not the central bank would soon reduce its easy-money policies.
The effect of such markets swings on returns is predicated on the amount of risk within a portfolio. Diversification across asset classes such as stocks and bonds can help set a portfolio’s overall risk level. That’s because the return of a well-diversified portfolio isn’t determined by the performance of a single asset.
Rebalancing maintains the desired mix of assets and overall risk level through the benefit of selling high and buying low.
For example, if an investor wanted a risk level of a 50/50 stock to bond portfolio but a bull market raised that allocation to 60/40, the portfolio is now exposed to too much stock risk. Trimming back to 50% stock by selling 10% will restore the proper risk level should there be a correction.
Periods of high market uncertainty are likely temporary
Reduced portfolio volatility, coupled with a rebalancing strategy, can also have a positive influence on investor behavior, which is important since the market reaction to disruptive events is often short term.
Consider that by October 2001 – only a month after the 9/11 – markets recovered to previous levels. And, when the Bernanke officially announced a reduction to the Feds bond purchases, investors reacted positively and continued an unprecedented streak of record-breaking market days. Investors that took drastic, immediate action during those periods of increased uncertainty may have missed out on strong returns.
The knowns investors know… and can control
The only thing investors should do during high uncertainty – all the time, actually – is concentrate on what they know they can control. Primarily, that is the mix of asset classes in their portfolios and the amount of money allocated to each one. Also, investors control when to rebalance those assets to maintain the desired amount of risk. If an investor’s overall portfolio is doing fine, then the market and all its short-term uncertainty should be less important in relation to long-term financial goals.
A final component investors can control is costs. Therefore, it is important to know the expenses charged by the funds within a portfolio. One way to control expenses is by investing in low-cost funds. Index funds and market-tracking exchange-traded funds (ETFs) are generally low cost, transparent and diversified since they attempt to replicate a specific index.
Diversification and rebalancing are features of efficient market theory, a finance theory supported by Nobel Prize-winning research that the market reflects all known information and that the most efficient portfolio is a total market portfolio because it is the most diversified. Whatever unforeseen events the future holds, be it man made or a force of nature, investors can be confident following diversification and rebalancing strategies that use known knowns rather than put money in investments with a lot of unknowns.