Investing in Volatile Markets

Investing in Volatile Markets

Volatility is inherent in capital markets. When we invest in the market, we expect volatility to play a part in our investment process; nevertheless, in times of market stress, the temptation to exit altogether is very strong. The S&P 500 moved 2% up or down in a single day for 30 days in between August and November 2011; that’s a 2% move in 35% of all trading days during that four-month period. Frenetic change like that is enough to deter some investors from participating in the market. Add to that the conflation of negative financial headlines presented in the media, and it is difficult to distill what is objective analysis and what is sensationalized coverage.

Volatility is a by-product of a nervous investor base. As was the case last summer, there was a pattern of risk-on/risk-off on a week-to-week, and even a day-to-day basis. Keeping a historical perspective, what transpired last summer was nothing new.  In fact, such drastic ups and downs have occurred less frequently in the last two years (2010 and 2011) than they did during the financial crisis of 2008, the dotcom-inspired bear market of 2000 to 2002, and further back, during the Great Depression. It is important to remember that volatility is mean-reverting, meaning that it tends to revert back to its long-term average over time. It is imperative not to give up on active investing after just one bad year.

Planning for Volatility

Volatility can be an opportunity to revisit one’s investment goals and objectives. Understanding your risk tolerance and marrying that with your expected rate of return is important. The objective is to find the optimal balance between these two points. One of the ways you can achieve this is by having a financial plan, developed through the financial planning process. A plan can ground uncertainties in the market and help you adjust to any new reality. Information is plentiful, but grounded assessment and judgment are scarce and valuable. Your plan should specify the appropriate risk-reward strategy for your personal situation. It should assume volatility and loss and calculate the probability of success of your goals. No one should take more risk than is necessary for long-term success.

Fear-Proofing Is Possible

It is difficult to go against the grain, especially if the world seems to be heading for the exit and selling. So how do you control or take emotions out of your investments?

It is ideal to invest in good times and in bad times. Invest regular amounts periodically. Set up automatic savings transfers or deductions from your paycheck. Automatic deductions take advantage of volatility through dollar cost averaging, for example. By continuously investing, you can take advantage of market volatility rather than just enduring it. The tax deferral benefits of a 401(k) or an IRA is a gift to investors. Think of an employer match as “free money”, and with an automatic savings or pay deduction, you can easily build up that retirement savings. IRA contributions are tax deductible, and therefore an IRA is beneficial in two ways – build up savings and decrease your tax liability.

Investing should include clear goals – whether it is for growth, savings, or income. Have a disciplined, appropriate investment process and plan. Timing the market almost never results in producing consistently better returns for the simple reason that unless you get in at a lower price, when things appear even worse and investor anxiety runs more rampant, you are effectively buying high and selling low.

In addition, understanding your risk tolerance is critical. If what happened in 2008 has taught us anything, it is that risk is sometimes inappropriate for some investors. A good investment strategy or plan should also take into account the appropriate risk allocation. It is not uncommon that an investor’s stated risk tolerance is actually quite a bit less than what his or her portfolio would imply.

Fundamentals and technical metrics eventually rule once investors’ fears ebb away and confidence comes back to the market. Investing in volatile markets requires a long-term perspective (relatively speaking). Market declines are a natural part of the economic cycle. Strategies, no matter how successful, go through ups and downs. The challenge for most investors in times of volatility is how to keep a cool head when everyone else seems to be losing theirs. Use your investment advisor and financial plan as a reliable assessment resource. The goal is not to cut loss but to make money over time and successfully fulfill your financial goals.

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