Staying invested when the news is bad

There is a peculiar gap in investing that has been measured repeatedly and never really closed. Over long periods, the return delivered by a typical investment fund is meaningfully higher than the return actually earned by the average investor in that same fund. The fund did well. The people holding it did less well. Nothing about the fund's management explains the difference. The difference is entirely a matter of when people bought and when they sold.

The behaviour is easy to describe and hard to resist. Money arrives after a period of strong returns, because strong returns are reassuring and get written about. Money leaves after a fall, because falls are frightening and get written about a great deal more. Buying comfort and selling fear is an efficient way to convert a decent investment into a poor personal outcome.

This article is about the thinking that makes it possible to sit still, and the planning work that should happen long before the bad year arrives.

Volatility is the price, not the problem

Cash in a British bank account will not fall in nominal terms. That feels safe, and over a two year horizon it largely is. Over twenty years it is nothing of the sort, because inflation compounds silently in the background. At three per cent inflation, the spending power of money left in a low interest account halves in roughly twenty three years. The pound is still there. What it will buy has gone.

Equity markets have historically delivered returns above inflation over long periods, and they charge for it in volatility. That is the arrangement. You accept that the value of your holdings will go down, sometimes sharply, sometimes for eighteen months at a stretch, and in exchange you get access to a return that cash cannot offer. Volatility is not a flaw in the system. It is the mechanism by which the return is delivered to people prepared to tolerate it.

Understanding that properly changes how a fall feels. A twenty per cent drop is not evidence that something has broken. It is the thing you agreed to when you invested, arriving on schedule.

Capacity and tolerance are different things

Most risk questionnaires measure one thing and call it risk. There are actually two, and they need separating.

Risk capacity is financial and objective. It asks what would happen to your life if the portfolio fell by thirty per cent and stayed there for three years. Someone with a secure income, a paid off house, a large cash reserve and fifteen years before the money is needed has high capacity. The fall would be unwelcome and it would change nothing about how they live. Someone intending to use the money for a house deposit in two years has almost no capacity, no matter how relaxed they feel about markets.

Risk tolerance is psychological and personal. It asks how you will feel, and more importantly how you will behave, while that fall is happening. Some people genuinely do not look. Others check daily and lose sleep. Neither is wrong, but they call for different portfolios.

The portfolio has to respect the lower of the two. High capacity and low tolerance means a cautious portfolio, because a technically suitable allocation that gets sold at the bottom is worse than a conservative one held throughout. High tolerance and low capacity means a cautious portfolio too, because enthusiasm does not pay a house deposit. This is the calculation that questionnaires with a single score tend to miss.

Timescale does most of the work

Before any conversation about fund selection, the useful question is when the money is needed. Not roughly. Specifically.

• Money needed within three years should not be exposed to equity markets. There is not enough time to recover from a bad start, and no amount of diversification changes that.
• Money needed in three to seven years can carry moderate exposure, with the mix shifting steadily towards safety as the date approaches.
• Money needed in seven to fifteen years can take meaningful equity exposure, because history offers reasonable comfort about recovery over that length of time.
• Money needed beyond fifteen years, or intended for the next generation, should probably carry the most exposure you can genuinely tolerate, because inflation is the dominant threat over that horizon rather than volatility.

Retirement complicates this usefully. A sixty year old is often told their timescale is five years. It is not. They may have a five year horizon for the first slice of income and a thirty year horizon for the rest of the pot. Treating a retirement fund as a single pool with a single date is the source of a great deal of unnecessary caution and a great deal of avoidable inflation risk.

What a fall actually costs if you sell

The arithmetic of selling into a fall is worth spelling out, because it is less intuitive than it looks.

A portfolio falling from £100,000 to £75,000 has lost twenty five per cent. To return to £100,000 it must now rise by thirty three per cent, because the gain is calculated on the smaller base. That asymmetry is uncomfortable but it works in your favour if you hold, because the recovery applies to everything you still own.

Sell at £75,000 and the problem changes shape entirely. The loss becomes permanent, and the recovery, when it comes, happens to money you no longer hold. Worse, the decision about when to return is now yours to make, and it is a decision with no good answer. Buying back in while markets are still falling feels reckless. Buying back after a strong rally feels late. Most people who sell in a crisis return considerably later than they left, at prices considerably higher.

Compounding this is the concentration of good days. Market returns are not spread evenly. A meaningful share of any decade's gains arrives in a small handful of trading sessions, and those sessions cluster inside periods of severe turbulence, frequently within days of the worst falls. An investor who steps out to avoid the bad days almost always misses the best ones as well, because they occur in the same fortnight.

The investor who does nothing during a crisis is not being passive. Doing nothing, deliberately, while your portfolio is down twenty per cent, is one of the hardest disciplines in personal finance.

Structures that make sitting still easier

Willpower is an unreliable plan. Structure is better, and there are several arrangements that make holding through a fall substantially more comfortable.

A cash buffer is the most effective by a distance. Someone drawing an income from investments who also holds two years of spending in cash never has to sell units at a depressed price to pay the gas bill. That single arrangement removes the forced selling that turns a market fall into a permanent loss. For those still working, an emergency fund of three to six months of outgoings does the same job.

Diversification matters, though less as a return enhancer than as a comfort mechanism. A portfolio spread across regions, company sizes, bonds and property will not fall as far as a concentrated one, and a smaller fall is a great deal easier to live with.

Automatic rebalancing enforces good behaviour without requiring you to feel brave. Trimming what has done well and topping up what has not is, mechanically, selling high and buying low. Doing it on a schedule removes the need to decide anything during the difficult period.

Regular contributions turn volatility into an advantage. Monthly investing buys more units when prices are low, so a long fall in the middle of an accumulation period, unpleasant as it feels, frequently improves the final outcome.

And a written plan, agreed calmly, is worth more than any of the above. A document that states what the money is for, when it is needed, and what was agreed would happen in a fall gives you something to consult that was written by a version of you who was not frightened.

The role of an adviser in a bad year

Advisers are commonly assumed to add value by selecting investments. Some do. But the larger contribution, measured across whole client relationships over decades, tends to be behavioural. Being the person who answers the phone during a crash and says that nothing has changed, that this was anticipated, and that the plan still works, is frequently worth more than any fund selection decision made that year.

That is not a comfortable thing to charge for, because it looks like inactivity. It is not inactivity. It is the difference between a portfolio that compounds for twenty years and one that gets interrupted twice and never quite recovers.

In short

Decide what the money is for and when you need it. Build a portfolio that respects both your financial capacity and your genuine emotional tolerance, whichever is lower. Hold enough cash that you are never forced to sell at a bad moment. Write the plan down while you are calm. Then let the bad years happen, because they will, and they are part of the arrangement rather than a sign that it has failed.

The value of investments and the income from them can fall as well as rise and you may get back less than you invested. Past performance is not a guide to future performance. This article is general information and does not constitute personal advice.