Why now is the time to prepare and protect portfolios

Investors tend to 'buy high and sell low' by chasing the managers who have recently done well and avoiding those who have done poorly.

But if the manager’s performance subsequently deteriorates or improves, the investor can be left with a substantial gap between the fund’s published track record and their actual outcome.

Studies show that this 'behaviour penalty' is typically about 5 per cent per annum — far more damaging to long-term wealth than the impact of costs and charges.

The right attitude toward risk

It also helps to be clear about the definition of risk.

The vast majority of academic research uses the historical volatility of returns as a proxy for risk.

To be fair, this makes sense in some cases. For example, if you have an important cash outflow on the immediate horizon — such as a down payment on a property or university fees — you would obviously want a high degree of certainty that you’ll have the money on the day when it is needed.

Apart from that, conflating risk with volatility in the academic sense can be dangerous in real life.

It is one thing to read about panics and crashes in a textbook, but quite another to experience them first-hand with real client money at stake.

Firstly, historical volatility can be a terrible predictor of future volatility. Just ask holders of the “XIV” inverse VIX exchange-traded note. They probably slept well knowing that the fund had a history of low volatility, until it was wiped out in one day.

Nassim Taleb puts it even more colourfully in his book, The Black Swan: The Impact of the Highly Probable. For 1,000 days in a row, the turkey sees his friendly farmer bearing food each morning. Until day 1,001 — just before Christmas — when the farmer instead shows up with an axe.

It is this type of permanent loss that we need to guard against rather than short-term market swings like those we have seen in recent weeks.

Short-term market fluctuations are essentially irrelevant if assets are properly diversified and not needed anytime, for example in a toddler’s Junior Isa, or a young worker’s pension pot.

If anything, the real risk in those instances is playing it too safe and failing to allow the power of compounding to work its magic and protect against erosion of purchasing power by inflation.

The right partners

So if an investor can’t time the market and they can’t rely on the usual notions about volatility, what can they do?

One solution is to seek expertise from those who have been there before — in other words, professional investment managers.