It appears volatility is back when it comes to the investment markets. For example, the Dow Jones Industrial Average either rose or fell by at least 100 points on three-quarters of the trading days in January of 2015. In addition, foreign exchange markets saw wild fluctuations in currency values that month, and yields on high-quality government bonds fell to levels not seen in years.
So what should investors do in the face of such changeability ? The first thing to do is come to grips with the fact that market volatility is normal. Markets have always gone up and down, and they always will — sometimes swinging wildly one way, only to swing back the other way just as wildly the next day.
You should also realize that market volatility is not necessarily a bad thing. As uncertainty increases, so does the opportunity to realize investment profits. The opposite is true as well: High volatility also increases the risk of steep losses.
Here are seven things to keep in mind as you navigate the turbulent waters of investment volatility:
- Your investment time horizon will impact how you deal with volatility. If you have a long-term investing timeframe — for example, you are investing for retirement or college for your young children — then short-term market fluctuations really should not impact you or your investments at all. Daily, weekly, monthly or even yearly market gyrations will have a relatively minimal impact on your portfolio over a period of ten to twenty years or longer.
In this scenario, it is often a good idea simply to avoid following the day-to-day movements of the investment markets — especially if such movements affect you emotionally. Do not watch CNBC every day or check MarketWatch compulsively. Sure, you should keep an eye on what is going on in the markets broadly, but don’t obsess over every couple-hundred point swing in the Dow.
If you have a shorter-term investing timeframe, though, you may need to pay more attention to volatility. In this scenario, you will have less time to make up for steep short-term losses. Money that you may need to access in the short-term — generally less than two or three years — should probably be invested in vehicles that are more stable and less risky, like CDs and money market funds.
- Your risk tolerance is another important factor in dealing with volatility. As noted above, high volatility tends to increase both the profit potential and the risk of loss of your principal. Take a hard look at yourself to determine where you are on the risk vs. return spectrum.
If you have a lower tolerance for investment risk, then your portfolio should probably be weighted toward less-capricious investments like those noted above. If your risk tolerance is higher, then you can probably stomach a little more uncertainty — especially if you also have a long-term investing timeframe.
- In volatile markets, diversification and asset allocation take on increased importance. Diversification is one of the best ways to guard against volatility risk. Simply put, this means spreading your assets out among the three primary types of investments: stocks, bonds, and cash equivalents. For example, you might decide to structure your portfolio with 50 percent stocks, 40 percent bonds and 10 percent cash equivalents.
Asset allocation takes diversification a step further by spreading your assets out among different types of stocks and bonds. For example, you might divide your stock allocation among large-, mid- and small-cap stocks and your bond allocation among U.S. Treasuries, municipals, and corporate bonds. When used together, diversification and asset allocation can lessen the impact of market fluctuations.
- Strategies exist to profit from volatile markets . Exchange traded funds (ETFs) and ETNs that track market volatility indexes enable investors to potentially profit from market volatility. The most common of these indexes is the CBOE Volatility Index (or VIX), which is sometimes referred to as the “fear index.” Among the top volatility ETFs and ETNs are the iPath S&P 500 VIX Short-Term Futures ETN (VXX), the ProShares VIX Short-Term Futures ETF (VIXY) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ).
- Remember that dividends can help smooth out returns during volatile markets. Unlike stock prices, dividends are not impacted by short-term market volatility. When markets are rising, dividends provide some extra juice for returns. When markets are falling, dividends help cushion losses since they are a component of an investment’s total return. If dividends are being reinvested, these compounded returns can boost total return even more.
- Trying to time a volatile market is a fool’s game. When markets start swinging wildly one way or the other, investors sometimes think they can time which way the market is going to move next. In reality, though, timing buy and sell decisions to coincide with market peaks and valleys is extremely difficult — and next to impossible to do on a consistent basis.
All too often, market timers end up buying high and selling low — the exact opposite of a successful investing strategy. Rather than trying to time an unpredictable market by jumping in and out at the perfect time, it is usually a better idea to ride out the volatility with a longer-term investing time horizon.
- Dollar-cost averaging is one of the best ways to combat market volatility. This is a simple strategy used by many long-term investors to reduce the impact of volatility on their portfolio by evening out the price per share that they pay for investments over the long-term. With dollar-cost averaging, you invest the same amount of money in a stock, mutual fund or ETF every month. This strategy is commonly used to invest for long-term goals like saving for retirement or college.
For example, suppose you invest $120 every month in a certain mutual fund in your retirement account. The first month, shares were priced at $30, so you bought four. The next month, the price rose to $40, so you only bought three shares. The following month, the price dropped to $20, so you bought six shares. After three months, you own thirteen shares at an average cost of around $27 per share.
With dollar-cost averaging, you actually benefit (at least in the short-term) when the market is falling because you pay less per share and, as a result, are able to buy more shares with your money.
Market volatility is neither good nor bad. It is simply a part of investing that all investors should understand and factor into their decisions. Keep these points in mind as you consider how the recent uptick in volatility could affect your own investment decisions.