The benefits of diversified, liquid portfolios when markets are stressed

Sport is often used as an analogy in investment, and sometimes people push it too far. However, there is one thing that I have long believed is a useful parallel, and that is how pressure can result in poor performance. The difference between the Rory McIlroy, Finn Russel and Lauren James's of this world and the rest of us, is that when we are trying to do what they do on a golf course, rugby field or football pitch we might occasionally do it very well; but not that often and probably when there isn't much at stake. They, on the other hand, can do it consistently well (even if not 100%) while under great pressure. That's the result of great skill and a lot of hard work. We could all, of course, spend hours improving our skills in our chosen sport, but what also helps is finding ways to reduce the pressure on us at those key moments.

That's where there are similarities with investing. Clearly, being skilful is an important factor and thus training and experience make a difference. But for all of us, finding ways to reduce the pressure on us when making decisions is also a big factor in creating a successful investment portfolio. For me, there are several key ways in which you can help to do that, and the second quarter of this year provided a reminder as to how helpful these can be.

First, have a clear and honest understanding of your time horizon, and if it is longer than whatever the current disruptive influences on the market are, then you are giving yourself an option to take your time to assess the situation, make your decision and, potentially take advantage of the opportunity the volatility might present. This is particularly true when you employ another other great reducer of pressure: diversification.  Diversification might not be perfect but having a diversified portfolio means that you are far more likely to avoid the worst drawdowns when markets are volatile. That means the impact of your negative holdings are mitigated by the impact of your positive ones; and the less correlated these are, the more mitigation you get. Having a more resilient portfolio, allows you, once again, more time to think through what, if any adjustments need to be made to it. Having liquidity is another pressure reducer. If you decide that you do have to make changes to the portfolio, then having liquid investments makes that so much easier to accomplish. Finally, being honest with yourself is a great help. Recognising always, that you will get things wrong means you are likely to build a portfolio that will take account of that - e.g. by being diversified and built to cope with a variety of scenarios, and not have to be torn up and started again every time the market background changes.

It is hard to avoid market volatility, but all of the above reduce pressure on you at times when markets are stressed. That means you can benefit from having more time to consider your decisions and make changes. It also means that you are less likely to over-react. Sometimes the smart decision is to do nothing - a course that is far easier to follow if you have a resilient portfolio, and a considered view of what is driving the stress in markets.

As I said above, the second quarter of this year was a good reminder of how these tools can help. In the first quarter of the year, investors had listened to what President Trump had said about tariffs and concluded, as we did, that while he would implement some, they would be relatively low and / or used as a negotiating ploy, to target the likes mainly of China and Mexico. When, on April 2nd it appeared that US tariffs were going to be far more punitive and widespread than expected, equity markets fell sharply. Fortunately for us, we had gone into that event with a diversified portfolio; and had not made any large asset allocation "bets". Rather, we had diversified within asset classes, by picking holdings that had differing characteristics, particularly when it came to the impact of the Trump tariff plan and also sensitivity to the USD.

Nothing works perfectly, and there were a couple of tweaks that we felt it necessary to make within portfolios; but we avoided any of the pressure to make those changes too quickly, or over-react and be whipsawed into making changes that prove costly later in the quarter, when Trump did what many of us had expected and pulled back from the more extreme stance he had taken in early April.

As a result of having liquid, resilient portfolios we had the benefit of being able to undertake only small changes and continue our existing strategy so that as markets recovered, our portfolios produced good results, with each of our strategies comfortably out-performing its ARC benchmark.