Navigating a Nervous Market

Keeping cool when stock market volatility heats up has its benefits. By MARK J. GILBERT, CPA/PFS, MBA | Summer 2018



In a year of unpleasant surprises — I’m personally talking about the Chicago Blackhawks failing to make the NHL playoffs for the first time in 10 years — perhaps the most frustrating and worrisome is the return of volatility to the U.S. and global stock markets. It affects our, and our clients’ wealth, and it’s something we haven’t had to stress over for nearly a decade.

Between Nov. 8, 2016 (Election Day) and Jan. 26, 2018, the Dow Jones Industrial Average, or Dow 30, rose more than 8,283 points, for a gain of more than 45 percent — a stunning return for just 15 months. But by March 31, just two months later, the Dow closed almost 2,514 points lower, for a quick loss of about 9 percent in reaction to growing geopolitical tensions, trade war talks, rising interest rates, and more. Then all the chatter about steep corrections, bear markets, and the party ending for stocks began.

We as investors may know that stock prices rise and fall daily. But in all honestly, it’s much easier to accept this investing truth during a year like 2017 where stock prices generally marched higher with no meaningful pauses or pullbacks, and certainly no “corrections” (a decline of more than 10 percent from the high). So far this year, it feels like prices fall more often than rise, volatility is back (the S&P 500 experienced swings of 1 percent or more in 51 percent of its Q1 trading days), and tensions and stressors are once again part of investors’ daily lives.

So, what gives? Should we worry about renewed market swings? Is there a way to profit from volatility? Or, is it time to seek out safe havens?

VOLATILITY: THE HISTORY

According to online financial news and information provider Investopedia, volatility is “the amount of price change a security experiences over a given period of time. If price stays relatively stable, the security has low volatility. A highly volatile security is one that hits new highs and lows, moves erratically, and experiences rapid increases and dramatic falls.”

Volatility is rarely a worry when prices are rising, but it quickly becomes an investor concern when prices reverse course. Financial analysts often refer to the VIX measure, or “Fear Index,” when discussing market volatility. The VIX is the ticker symbol for the Chicago Board Options Exchange’s (CBOE) Volatility Index, a weighted measure of the implied volatility of multiple S&P 500 put and call options. Like stock prices, the VIX is computed continuously throughout the trading day. The VIX standing at 30 or more implies greater stock market “fear,” aka volatility, while a drop below 20 means little to no significant stock market volatility persists.

According to the CBOE, the average VIX index daily closing price between 1990 and 2017 was 19.37, with a range of 9.14 to 80.86. In 2017, the VIX range was 9.19 to 16.04. However, in just the first quarter of 2018, the VIX range expanded to 9.15 to 33.46. Clearly, volatility is making a strong comeback. But it’s important to remember that we’ve seen periods of high volatility before, as evidenced by the significantly higher end of the long-term range (80.9) versus the current period range (33.5). It’s fair to say that, in general, the recent volatility we’ve experienced in the market should be no more worrisome to investors than past periods of elevated volatility. In other words, I don’t believe we are seeing anything new here even if it feels uncomfortable for the time being.

PROFITING FROM VOLATILITY

One way to take advantage of this edgy environment is to purchase exchange-traded funds (ETFs) and other investment products designed to rise in value in times of relatively higher volatility. Essentially, these products hold VIX options and futures contracts and may also use leverage to enhance returns. This isn’t without risk, so I recommend these for short-term trading vehicles rather than long-term holdings. Accordingly, you’ll need to monitor price changes closely. Timing the markets is never easy, but active traders can further use these vehicles to profit from market swings or hedge their bets.

Investors with long time horizons, say 10 years or more, should embrace higher volatility, which will help rather than hurt in the long run. While it may be difficult to watch the ups and downs of your portfolio value during this period of higher volatility, keep in mind that you aren’t actually affected until you sell off investments and start making withdrawals. Second, the longer you’re in the market before needing the funds, the better the odds that your portfolio value will recover from any prolonged retractions.

Further, volatility also helps if you’re regularly making deposits and stock purchases in your portfolio, like payroll contributions in a 401(k) plan. This is because at least some of those deposits will be made at lower/falling stock prices and your fixed deposit amount allows you to purchase more shares, relative to higher prices. As the market recovers, those incremental share purchases will further increase your portfolio value. Younger investors will benefit the most from this strategy, to whom I recommend an aggressive allocation of U.S. and international growth-oriented stocks and/or low-cost ETFs, index, or mutual funds.

Middle-aged investors that have a somewhat shorter time frame before drawing assets from their portfolios should be more mindful of their investment strategies but can still use volatility to gain an advantage. While I recommend the same process as above, the exception is that slightly less aggressive investment allocations should be established. Generally, I also recommend building larger positions in interest-earning cash, fixed-income bonds, and dividend-paying stocks and funds.

VEERING FROM VOLATILITY

As for aging investors and retirees, be warier of renewed market volatility. Presumably, you have less time to recover from any market losses, so high volatility can really upset your long-term plans. The key here is to invest more conservatively — maybe even more conservatively than your investment risk tolerance would lead you to believe. The same can be said for very risk-averse investors.

Ideally, commit to individual stocks or funds only the portion of your portfolio that you’ll draw from in 10 years or more. If doing so leaves you with little or nothing to invest in equities, then gradually reduce the “waiting period” to use your portfolio assets to as low as six years to maintain some exposure to equities. At each successively shorter period — nine years, eight years, etc. — estimate the amount of equities you can comfortably hold in your portfolio. It’s critical at this stage in life to maintain some allocation to individual stocks or funds to increase your odds of offsetting rising inflation and income tax rates.

If you find that you will likely draw down funds from the portfolio in less than six years, then rethink your spending habits. Either reduce spending, or if possible, remain in the workforce for a longer time to defer drawdowns from your accounts.

Late-stage career workers and retirees should also work with a financial planner. A detailed plan can help you make better decisions about asset allocation, portfolio design, goal setting, and spending. At this stage, you cannot afford to make significant financial mistakes.

As investors, we must embrace the truth that stock market volatility rises and falls. While the current environment represents a period of relatively higher volatility than we’ve seen in recent years, using the tools and information available to investors today will only help in the long term. Don’t let emotions get in the way of potential profits. When volatility heats up, keep your cool and put your capital to work.