Don’t let uncertainty ruin your portfolio

Years ago, a team of researchers published their work on the relationship between uncertainty and stress. This very precise study corroborated the conclusion of other studies, that stress is highest when uncertainty is highest.

Uncertainty is intrinsic to the human condition. And we feel it even more today - living in a time of unrelenting upheaval and unease. We like to be in control. We admire others “who are in control”. And uncertainty doesn’t allow us to be in control.

If high uncertainty is unavoidable and is leading to great stress, what must we do to prevent behaviours that will defeat us? What is really in our control?

The real existential threat to your finances is short-term thinking.

Morningstar’s director of behavioural finance, Sarah Newcomb, says that short-term thinking is linked to increased impatience and discounting of future rewards, impulsive decisions, higher debt, lower savings, excessive risk-taking, and poor health decisions.

Uncertainty can make short-term thinkers of the best of us. It is hard to plan for a 20-year time horizon when you can’t see past next week.

To maintain your cool as a long-term investor, you simply must find ways to see past the immediate crises. Do this by turning your attention away from the uncertainty of things we can’t control and toward things that we can control.

One way to do this is by rounding out the story. This just happened; what's the right thing to do? If the market has fallen dramatically, it means you look for bargains. If it is rising rapidly, you revisit your asset allocation which probably has gotten all skewed in a soaring bull market. Viewing the same data and same market movement with a different narrative has a very different outcome.

If you are anxious because you are holding a portfolio that is heavily overweighted in one sector or asset class, you may want to ask yourself some questions about how that came to be the case.  What does this overweighting tell you about your true appetite for risk and reward, and how can you use this information to help you make decisions going forward?

Holding a large percentage of your assets in just a few stocks is an extremely risky business regardless of any circumstance. Sitting on too much cash means missed opportunities for growth. If your portfolio is undiversified, you’re at risk for losses.

Steve Wendel, Morningstar’s head of behavioural finance, says that the Recency Bias is always very much at play. Your mind thinks that what is happening right now will continue, at least for a long time. This happens when the market is going up or down. He suggests that we analyse that choice from another perspective. “Stress test your choice. Decide not to act till you give it a few more days. Explain it to your friend or spouse or financial adviser. If it’s a solid thoughtful decision, it shall withstand.”

Here’s some practical advice from Mahesh Mirpuri. In times of uncertainty, focus on what you can control.

Asset allocation is a time-tested principle that provides stability to a portfolio and insultation against volatility. No matter what your age or portfolio worth, this must never be ignored.

The first step to creating any portfolio is to narrow down on the equity and debt combination.

The equity part provides the growth and the bulk of the returns. Allocation will rest on three factors: a) when you need the money, b) an honest appraisal of your capability for risk, and c) the volatility you can stomach.

The debt part plays the role of the anchor, providing a stable base. Hence, safety must be the main consideration. The prime aim of debt is capital preservation and stability to the overall portfolio. It is supposed to make it easier to stomach risk elsewhere in the portfolio. Investors can inadvertently sabotage their portfolios by trying to juice returns by adding risky debt (low-rated paper that gives higher returns or credit funds). Be it liquid funds, ultra-short term funds, bond funds, fixed deposits, or small savings, their purpose is to provide liquidity and stability.

You can also consider gold also as part of the 'stable anchor' of the portfolio.

If you keep your eyes fixed on periodic rebalancing, the volatility and the drawdowns will have a much lesser psychological impact on you. Asset allocation helps you prepare for what you cannot predict.

An investor education initiative by Edelweiss Mutual Fund

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