Managing Emotional Volatility

Ask a CIO #31

How do you manage emotional reactions after stock market selloffs? Do you have any recommended coping mechanisms?

U.S. stocks have had a rockier start to the year, though this week hasn’t been too bad. That said, it’s a great question. If history is any guide, stock market selloffs are inevitable and a natural part of the stock market investing experience. The timing for any such selloff is, of course, not so clear.

I don’t know if you’re asking for my personal emotional reactions (generally limited) and coping mechanisms (crossword puzzles), but I’m going to answer this question through the lens of an institutional investment office. This way, I can highlight some of the structural mechanisms that institutions often put in place to promote better decision making. And then we can consider how an individual investor might replicate some of those things.

So what does the inside of an institutional investment office look like during a market selloff?

Let’s first talk about what an investment office looks like in general. There’s the investment team, comprised of full-time, professional investors. There’s the portfolio itself, governed by an investment policy statement and a strategic asset allocation policy. Within the portfolio, there are fund investments in managers with domain expertise across public and private markets. Then, above it all, is the Investment Committee, which provides oversight to both the investment team and portfolio.

Let’s also take a moment to consider the steady state composition of a hypothetical institutional investment portfolio. It likely includes allocations to private fund investments (e.g., private equity, venture capital, real estate, natural resources, etc.) that can’t be changed, regardless of the market environment.¹ It probably also includes investments to commingled funds (including but not limited to hedge funds), which are not as illiquid as private funds, but are generally not daily liquidity. Collectively, there is likely a sizable portion of the portfolio, if not an overwhelming majority, that can’t be changed on a dime.²

And because the portfolio accepts varying degrees of reduced liquidity across investments, the investment team generally prioritizes deep due diligence on new investments and active monitoring of existing investments. In other words, the investment team knows well what the portfolio owns.

As you can see, investment offices are designed to encourage deliberate (some might say slower) decision making. There are a number of friction points that force reflection and slow down action, making it easier for the investment team to manage emotional reactions.

So, as unexciting as it may sound, when a meaningful market selloff occurs, the investment office will carry on as it usually does, just in a more expedited way. It will collect data, assess the current portfolio, and discuss among the team (and potentially the Investment Committee). Any decision would be made against the backdrop of well-defined asset allocation targets – the portfolio north star, if you will – and within the portfolio’s liquidity constraints.³

For an individual investor, it would be difficult to fully replicate the institutional investment office approach. But there are some high impact choices that could translate:

1. Establish asset allocation targets⁴

2. Know what you own (or conversely, own what you know)

3. Consider adding friction points that will force you to slow down and reflect (even if only briefly)

One admittedly significant institutional advantage is having a team of informed, full time professional investment peers with whom to discuss concerns. I unfortunately don’t think that is as replicable for individual investors, which arguably makes the other processes more important to consider.⁵

Thanks for joining, and as always, feel free to reach out: askacio@ivyinvest.co!

Until next week,
Wendy

1. I’m excluding here the possibility of private secondary transactions, which would generally be lengthy processes anyway.

2. Depending on the nature of the market selloff, certain portfolio investments may call capital to take advantage of investment opportunities.

3. Including possibly increasing investments when market selloffs present dislocated opportunities.

4. Some wiggle room is fine. Institutional investors typically have bands (e.g., +/- 5% compared to the target asset allocation).

5. If anything, individual investors might be plagued with the inverse.