Over the long term, investors are rewarded for cutting out noise during market volatility, not panicking, and focusing on their financial objectives. Staying invested rather than selling investments during volatile periods can result in superior long term investment returns. Whilst this is harder than it seems when human emotion is factored in, there are ways to mitigate emotional decision making.

Investment market volatility is not a new phenomenon. Since modern stock markets began hundreds of years ago, market fluctuations have been a constant feature, with periods of prosperity inevitably followed by periods of downturn. These ups and downs are typically the result of changes in company profitability, economic growth, interest rates, inflation, and global events, to name a few.

The 2020s have experienced numerous global and geopolitical events which have led to increased volatility, including the COVID-19 pandemic and various international conflicts. These events, combined with the widespread accessibility of news via technology and social media have heightened investor anxiety, often resulting in emotional investment decisions.

Statistical evidence

Using the S&P500 index, which measures the performance of the largest 500 publicly listed companies in the US, if you had missed out on the best performing 10 days in the index over the past 20 years, your investment returns would have been reduced by approximately half*. Moreover, 6 of the best 10 days have occurred within 2 weeks of the 10 worst days, often hinged around negative global news events. Making the decision to sell your investments when markets experience these short-term declines can therefore severely impact your investment returns over the long term.

Declines in markets are not uncommon either. The average intra-year maximum drawdown, (the movement from peak to trough in a specific year) has been c.14% since 1981. That means that, on average, within each calendar year since then, the stock market has fallen by around 14% at some point in the year. However, more often than not it recovers. It has only ended the calendar year at a lower point than at the start of the year in 10 out of the last 45 years**.

Understanding that the short-term declines are a natural feature of investing in stock markets, rather than a failure, can help investors avoid panic selling and remain focussed on their longer-term financial goals.

*Source J.P. Morgan Asset Management

**Source UBS

Human emotion: losses usually feel worse than gains

Despite the statistics illustrating that markets usually bounce back, it is very natural for people to feel uncomfortable when their investment portfolio falls in value. Your investment portfolio is often the result of hard work and lifelong savings invested in a pension or ISA, for example, and seeing the value of it fall can cause unease, even for experienced investors.

Human nature dictates that we feel losses more than we feel gains. For example, you would feel an investment loss of £1,000 more than the ‘feel good’ emotion from a £1,000 investment gain. A commonly sourced theory called ‘prospect theory’, developed by Daniel Kahneman and Amos Tversky in 1979, illustrates that we psychologically and emotionally feel the impact of perceived losses around 2 times more than perceived gains. In other words, you would need a £2,000 gain to offset the hurt from losing £1,000.

This demonstrates why some investors sell their investments when markets experience volatility as a result of the emotion attached to losses. However there are ways to avoid this.

What can you do to avoid emotional decision making?

Working with a financial planner

Having a clear financial plan, supported by cashflow modelling, can help cut through much of the short-term noise when investment markets are volatile. Human emotions are not always rational, and periods of market uncertainty can make it more difficult to remain focused on long-term objectives.

In the era of AI, many processes are becoming more efficient, with technology increasingly being used for data gathering, portfolio analysis, and administration. However, financial planning is about more than processing information. It involves understanding an individual's circumstances, priorities and concerns, particularly during periods of uncertainty. While AI can support analysis, it can’t fully replicate the judgement, empathy, and personal understanding that comes from an experienced financial planner. A financial planner can help you weigh up complex decisions, provide perspective during market turbulence and keep your long-term goals in focus.

Cashflow modelling

Cash flow modelling is a financial planning tool that forecasts your future income, spending, savings, and investments so you can understand whether you're on track to meet your financial goals. Cashflow modelling can be extremely beneficial as it can help you to view your investment portfolio within the context of what it should achieve over decades, the rest of your lifetime, and beyond, rather than the ups and downs it experiences each week or year. Regularly reviewing the plan can ensure that you remain on track to meet your financial objectives.

Time horizon

Every investor is different. You may be building a portfolio to fund your retirement, or, you might have recently retired and are preparing to start drawing on your investment portfolio for the first time to replace the loss of income. The former has a long investment time horizon to ride out any short-term market volatility. The latter has a much shorter time horizon and will have a greater need to preserve the capital you have worked hard to build up. Being clear on your investment time horizon will enable your assets to be invested in the most suitable way.

Diversification and risk

Ensuring that you have the right mix of assets, such as equities, bonds, and cash, to align with your risk tolerance, time horizon, and financial objectives can reduce the possibility of panic selling when markets experience fluctuations.

Emergency fund

Having an amount held back in cash outside of your investment portfolio means that you are less likely to need to draw on your portfolio in case of unforeseen costs or income need. The desire to take money out can be heightened during volatile periods.

Conclusion

Volatility is the price you pay for the potential of long-term investment growth and improving your financial position over time. During periods of market turbulence, constant news coverage, social media commentary, and increasingly AI-generated opinions can make it tempting to act on emotion rather than evidence. However, there are steps you can take to mitigate the concern you may feel during periods of uncertainty.

Understanding that volatility is a natural part of investing, maintaining a long-term perspective, and having a clear financial plan can help investors avoid making reactive decisions. A financial planner can provide perspective, discipline, and a structured investment strategy, helping investors remain focused on their long-term financial goals during periods of uncertainty.

Buzzacott Financial Planning is authorised and regulated by the Financial Conduct Authority. This article has been prepared to keep readers abreast of current developments. Professional advice should be taken in light of your circumstances before any action is taken or refrained from. The value of investments, and the income from them, may go down as well as up and investors may not get back the amount originally invested.