I recently came across an article titled “Stock Market’s Soaring Volatility Mirrors 1987 Crash.” Yikes! Does this mean another crash is coming? The article stops short of predicting a crash. It does, however, talk about similarities in the amount of volatility experienced in the 2018 stock market thus far and the volatility of 1987 before the October 19th crash.
Let’s talk about what volatility is. Many in the financial press use the word “volatility” to apply only to sudden downward movement in the stock market. The 2017 stock market, which resulted in the S&P 500 index rising 21.8%, was not considered volatile by financial journalists. However, after the S&P 500 index peaked on January 26, 2018, it dropped 10.1% over the next 13 days. The news has been filled with stories about the return of volatility ever since.
“Listen to market strategists, and a word that comes up a lot these days is ‘volatility.’” – Kelly Evans, co-anchor of CNBC’s Closing Bell.
This would lead the average investor to think the market is only volatile when it goes down. Therefore, volatility is bad. No one wants bad things to happen to their investment portfolio, and thus, we should seek to reduce volatility. Investors start confusing volatility with risk, i.e., a volatile stock market is a risky stock market.
Hedge funds love when investors start thinking this way. One way to reduce volatility is to add “non-correlated asset classes” to your portfolio. Theoretically, when stocks go down, a non-correlated asset does not go down. It may even go up, leading some to believe the investor’s portfolio is less volatile, and therefore, less risky.
Let us assume for a minute that this strategy works the way it is presented, because there is no way to know that it will. We all know that “Past performance is no guarantee of future results” and “Investments may lose value.” However, if the investor takes some percent of their portfolio out of stocks and invests in non-correlated assets, wouldn’t those asset values go down when stock prices are moving up? That is what non-correlated means. When markets work the way they are supposed to, would the reduction of volatility ultimately result in a lower return?
Take Advantage of Volatility
I look forward to market volatility and encourage my clients to embrace it. As investors study the tea leaves daily to determine where the economy is going and what companies will benefit, it is natural to assume some stocks are going to be mispriced. They will be overvalued during times of euphoria and undervalued when fear grips the public. Successful investing is not about anticipating these events in advance. No one can do that consistently. A successful investor seeks to take advantage of opportunities as they present themselves.
“Traders can cause short-term volatility. In the long run, the market must revert to a sensible price/earnings multiple.” – Ben Stein, American writer, lawyer, actor, and commentator
Successful investing does not rely on jumping in and out of the market. Success is having a long-term financial plan that includes a strategy to reach its goals. The strategy should call for an allocation between fixed investments, like bonds and CDs, and growth investments (stocks). Volatility creates opportunities to implement the strategy. A sizable move in the market should prompt the investor to rebalance their portfolio. The portfolio may have too much money in fixed investments when the market goes down. This is the time to buy low. Sell fixed investments and buy stocks to rebalance back to the levels outlined in your strategy.
“Stock market goes up or down, and you can’t adjust your portfolio based on the whims of the market, so you have to have a strategy in position and stay true to that strategy and not pay attention to noise that could surround any particular investment.” – John Paulson, fund manager, subject of The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History, by Gregory Zuckerman.
Investors should also think about tax opportunities created by market volatility. A big run-up in stock prices should prompt a charitable investor to make charitable gifts now with appreciated securities. Use a donor advised fund to separate the tax event from the charitable gift. A steep drop in stock prices may create the opportunity to harvest unrealized losses. Capital losses can be used to offset capital gains in the future. A net loss can be used to reduce other taxable income up to $3,000. Net losses greater than $3,000 will carry forward to future tax years – they never expire. A steep drop in the stock market could also be a good time to convert an IRA to a Roth IRA. The investor will be moving tax-deferred assets to tax-free while the valuation is low. Growth in a Roth IRA, when the market recovers, will be tax-free.
Finally, volatility can provide an opportunity to improve your portfolio. Get rid of underperforming positions that you may have been reluctant to sell because of tax implications. Upgrade your investment portfolio while prices are down.
Remember that volatility is our friend. Embrace it.
Interested in learning more about how to navigate volatile times in the stock market? Contact us today to speak to one of our financial advisers.
- Don’t confuse volatility with risk.
- Seeking to reduce volatility could reduce the portfolio’s return when using non-correlated assets.
- Rebalance your portfolio when the stock market makes a big move up or down.