How to Keep a Cool Head in Any Market

If you've been following the markets recently, you might be feeling a bit stressed. With this kind of volatility, it's hard not to experience the sense of worry that comes with watching your investment account balances falling.

What do you do in this situation? You might be debating whether to sell, change strategies, buy something, ride it out, or even bury your head in the sand. The decision-making process as an investor is daunting as it is -- and research shows that you are probably at your worst right now when it comes to making any decisions.

Here's what you need to know and how you can keep a cool head in a volatile market.

Stress leads to bad decisions

Research has shown that financial stress leads to worse decision-making. In other words, a bad situation can lead to worse results. Sugarcane farmers in India provide a good example: One study found that farmers performed worse on an intelligence test when under financial pressure (just before the harvest) than they performed during the relatively flush period after the harvest.

The farmers' results dropped the equivalent of 10 IQ points when they were under strain. They had less mental horsepower right when they needed it most.

The phenomenon can be attributed to the effects of scarcity. Because financial stress takes up so much mental energy, it leaves less mental processing power for everything else. The brain is like a muscle in this regard: Put it under heavy strain, and eventually it gets exhausted.

It's a lesson that can be applied to investing as well. Letting the stress of a bad market get to you can be hazardous to your portfolio, because the stress actually tires your brain out. Thus, the decisions you make might not be the right ones from a big-picture perspective.

There are two strategies you can use to deal with this.

Build slack into the system

One good way to help you deal with scarcity is to cultivate its opposite: abundance. One of the sugarcane-farmer researchers, Eldar Shafir, describes this as building slack into the system.

Diversification is the oldest form of "slack" when it comes to investing. Spreading your capital across different asset classes reduces the risk that a single one will sink your portfolio. The less correlated each asset class is -- that is, the less any given asset class is affected by the performance of the others -- the better off you'll be.

Of course, the best way to choose asset classes and allocations is a subject of debate. Depending on your risk tolerance, you may want to keep a mix of U.S. and foreign equities of different sizes, as well as some fixed-income investments such as corporate bonds and Treasuries. The best allocation for your situation depends on your appetite for risk, your goals and interests as an investor, and your overall financial position.

Another way of building slack into the system involves diversifying into non-investment assets or insurance. This could be as simple as holding cash in the bank, or it might mean investing in physical assets such as property . Those who rely on their portfolios for income could also consider buying an annuity.

Put your head in the sand

While acting like an ostrich in the face of bad news tends to be derided, research shows that it might actually be good for your portfolio.

One study found that ignoring bad news and avoiding looking at account balances had a positive effect on portfolios. That's because "ostrich" investors are too busy putting their heads in the sand to trade, and in the long run this tends to be a good strategy for riding out volatility. The more you trade, the less time you have to reap the gains of a solid investment and the more likely you are to rack up fees. Trading a lot may seem low-cost in the moment, but it's a very expensive habit over time.

While the study found that ostrich investors tended to share many other characteristics (male, older, invested heavily in equities), anyone can benefit from this strategy -- provided it's deployed correctly. The idea isn't necessarily to ignore the news, but rather to refrain from adding to the commotion by changing your strategy under duress.

Instead, set some trading rules for yourself and stick to them. You might rebalance your portfolio only when your asset allocation goes outside certain parameters (for example, 10% off your target allocation) or at certain times, such as once per year after a review. If you own equities, consider using stop losses to provide a safety buffer on how much you can lose on that particular stock.

Aside from setting rules, avoid the temptation to churn the waters in response to news. The activity might make you feel better in the moment, but it won't improve your portfolio's performance in the long run.

Diversifying and selectively ignoring your portfolio can provide the big-picture perspective you need to get through a tough market. By seeing the forest for the trees, you'll have an easier time taking the media hysteria in stride -- while hopefully getting a bit more sleep at night.

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