The Economist: How to invest in chaotic markets - the number one rule: keep a cool head

Just ignore it. That, in short, is the advice given to retail investors when stockmarkets convulse, as plenty have over the past few weeks.

Watching hard-earned savings disappear in a flash tends not to promote a cool head. So do not check your portfolio, do not tot up your losses and, above all, do not decide that now is the time to overhaul your entire investment strategy. Simply wait for the storm to pass and for share prices to resume their long march upwards.

In so far as it dissuades the nervous from panic-selling right after a big drop, such advice is sensible, even if the investment platforms dispensing it are hardly acting out of altruism.

“It’s about time in the market, not timing the market” is a mantra with particular appeal to those who charge fees in proportion to the time their clients spend in the market, after all.

Yet the idea that doing nothing is the only proper response to volatility is also deeply unsatisfying — so much so that it stretches credulity.

Everyone knows that markets can overreact, and that wild swings in prices may be caused by technical factors rather than changes to economic fundamentals. That does not mean they convey no useful information at all.

So how should you respond to the turbulence that has swept markets this summer? Start with the immediate effect on portfolio allocation.

Suppose that your strategy is the classic one of keeping 60 per cent of savings in shares and 40 [er cent in bonds. After the upheaval of recent weeks, these two sides will now be out of whack. Share prices have fallen while bond prices have risen. Although this provides just the cushioning effect that makes the 60/40 strategy attractive, your split will now have shifted to something more like 56/44. In other words, the buffer of bonds is too large compared with the stocks that will drive long-run returns.

However jumpy markets are right now, at some point, you will want to restore balance. Doing so now would entail selling bonds that have just become pricier to buy shares that have become cheaper.

No time like the present, then. In practice, though, such opportunistic rebalancing is easier said than done: it always seems worth putting off in case share prices fall even further, and the moment is missed.

Therefore it is best to forget about perfect timing and instead commit to a regular schedule (rebalancing at the end of each quarter, say, or each month) regardless of what markets are doing.

Intrepid number-crunchers might want to go further, making use of the new information revealed by the tumult. When bond prices rise, their yields, or the prospective returns from holding them to maturity, fall. When stock markets plunge, their expected returns go up. Share-price volatility, meanwhile, implies that the spread of possible outcomes on either side of these expected returns has widened, making the investment riskier.

Put all this together and you can derive the “Merton share”, a formula for optimising a portfolio’s split between stocks and bonds based on market conditions and your own risk appetite.

It says that the share allocated to stocks should be proportional to their excess expected return above that of bonds, and inversely proportional to both the square of volatility and the investor’s risk aversion.

Each of these variables, except the last, is liable to change in a crash. Retaining a balance of risk and reward that you are happy with may entail updating your portfolio allocations in response.

Step back from such whizzy theory, and the downsides of intervention amid market chaos are plain. Professional traders may be able to swap from bonds to stocks almost immediately; mere mortals often face days-long delays during which prices leap around even more.

If they move in the wrong direction, rebalancing might mean booking a substantial loss.

Doing so too often might involve trimming holdings of assets with momentum, causing you to miss out on subsequent gains. If you are to change your allocations at all, it must be via a procedure devised during calmer times, rather than a rash decision taken when fear is in the air.

Adopting a new strategy, even one with rigorous grounding like the Merton share, is unwise.

It is too easy to use the switch as an excuse to offload assets you are panicking about.

None of that, however, means that investors should simply ignore market madness.

Price swings do not need to be rational to change your portfolio’s positioning and prospects. A response, devised in advance, may well be in order. So keep your eyes open — provided you can keep your head while doing so.