Market volatility is much like the waves of the ocean. Sometimes, market fluctuations are nothing more than tranquil ripples, barely perceptible. At other times, they resemble towering white caps, frightening enough to rattle even the most stoic investors.
While heightened volatility isn’t fun for most investors, managing it effectively is crucial for maximizing long-term investment returns. Investors can follow certain investing strategies to navigate through volatility and possibly even use it to their advantage. These strategies are powerful when used independently but are more impactful when combined to interact with one another.
Create a plan, then work the plan.
Ideally, investors will have prepared for volatility while in a “cold state” free from market-induced stress. The foundation of this preparation is an Investment Policy Statement (IPS). Think of an IPS as an investor’s “constitution”—a timeless document of long-term personal investing principles that remains relevant in almost all situations.
A good IPS should address several considerations. In what asset classes should investors participate? And in what proportions? The answers to these questions will be based largely on individual risk tolerance and how soon an investor will need access to these funds.
Once a long-term target asset allocation has been determined, it may be helpful to determine how a similar allocation performed during previous periods of meaningful volatility. How big was the drawdown during its worst month, quarter, and year? How long until the similar portfolio recovered?
If the answers to these questions make investors uncomfortable while considering them hypothetically during a cold state, it’s very likely that they will be just as uncomfortable (probably more so) if and when such drawdowns happen in reality, and they may want to reduce the risk profile.
Since the beginning of our time on earth, humans have turned to the fight-or-flight response for survival when facing extreme stress. While it’s been a while since we humans have had to choose to run or fight when approached by a saber-toothed tiger, this reaction remains one of our survival mechanisms to this day.
The fight-or-flight response often kicks in during huge market swings because they can be associated with danger—the danger that the nest egg built up over years of hard work and diligent saving will be permanently decimated, the danger that a retired couple will run out of money, or the danger of some other associated calamity. And in an attempt to remove themselves from perceived danger, investors may sell their investments just to “get out.” But in many cases, as we shall see, this is exactly the wrong thing to do. Therefore, heightened emotions (whether fear at the bottom of a steep sell-off or greed at the top of a stock-market bubble) are one of the worst enemies of investors.
One way to manage emotions is to find and keep the appropriate perspective, which can often be done by using history as a guide. Downturns are, in fact, common and usually relatively short-lived. According to data provided by Fidelity, during the past 35 years, the S&P 500 has experienced an average drop of 14% from high to low during each calendar year but still had a positive annual return in more than 80% of the calendar years in this period.
Further, skeptical investors may want to consider that the S&P 500 has never had a meaningful correction or bear market that it didn’t recover from to ultimately reach new highs.
It seems logical that investors would want to pull funds completely out of the market at the first hint of volatility, ride out the downturn on the sideline, and go back in at the beginning of the long ensuing bull market. The problem is that very few investors can do that with desired precision, fewer can do it well, and still fewer can do it consistently. Investors will more likely sell too early (missing on further upside), sell too late (locking in losses and potentially triggering unnecessary taxable events), or wait too long to get reinvested.
And waiting too long to get reinvested can adversely impact investment performance. Much of the upside of any given bull market is generated within a relatively small number of days. Consider the following hypothetical example, which shows the difference in ending portfolio values among investors who miss even just a handful of the best days of a market rally:
Take advantage of market volatility.
One of the byproducts of negative market volatility is that assets are now available at lower prices. Assuming that the sell-off didn’t start from extreme valuations (i.e., bubbles) and that long-term fundamentals haven’t changed much, these lower prices could represent relative bargains.
If an investor is currently saving, they should continue to invest in such an environment. Averaging in during a market downturn allows investors to buy more at lower prices, reducing their overall cost basis. This will enhance total future returns once the market reverses course.
What if an investor doesn’t have the opportunity to save at the moment or is already retired? Here, too, investors can take advantage of opportunity. During a significant correction, chances are the current asset allocation has deviated from their target allocation—for example, the percentage in stocks is probably now a lower percentage than what is called for in their IPS. Investors can rebalance their portfolio to long-term target allocations. In this case, investors would be selling an asset that had appreciated (or depreciated less) during the downturn, using proceeds to buy additional equities that are now on sale with ostensibly greater upside potential—a classic “buy low, sell high” scenario.
Seek professional advice.
Many can’t or don’t want to manage volatility themselves and turn to advisors for assistance. It’s easy to lose confidence in markets and make quick investment decisions that may or may not be in your best long-term financial interests. There is value in experience, and we encourage you to seek advice from a qualified, fiduciary wealth advisor.
At Clayton Wealth Partners, we are Topeka-based, full-time fiduciary financial advisors, and we are here to help with navigating market turmoil, asset management, financial planning, and other important money matters. Please reach out to us. Our financial advice is focused solely on your best interests.
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