Volatility may be the day trader’s friend, but it can steal the dreams of long-term investors preparing for college and retirement.
And it has picked up in recent months. The CBOE volatility index, or VIX, a measure of volatility in the Standard & Poor’s 500 index, spiked to nearly 40 in February after spending most of last year in the low single digits. It has settled down in recent weeks but has been high enough often enough this year to get the attention of investors and market experts.
“Volatility is here to stay and I believe there will be more violent swings,” says Mark Charnet, CEO of American Prosperity Group in Pompton Plains, New Jersey.
While volatility means investments have big gains at times, the losses may be more significant, says Bradley R. Newman, director of financial planning at Roof Advisory Group in Harrisburg, Pennsylvania.
[See: 9 ETFs for Nervous Investors.]
“Successful investing is less about capturing 100 percent of the market’s upside and more about missing the potholes,” Newman says, arguing that strategies like diversification pay off in the long run because they dampen losses in downturns, even if they also trim the gains when assets spike.
The investor preparing for retirement decades away can wait out brief periods of higher volatility, but dips can be brutal for investors just entering retirement or facing an immediate expense like college tuition. Day traders try to jump in when prices are down and sell at the peaks, but studies show they often get the timing wrong, and this kind of bet is definitely not for amateurs accustomed to simple strategies built around funds.
The financial crisis that began 10 years ago demonstrated how damaging volatility can be for people with immediate financial needs, leaving many with portfolios too small to last for a long retirement. Retirees who needed a fixed income from their portfolios found they were suddenly taking a much larger percentage of their holdings each year, making it much harder for the portfolio to recover even though the markets rebounded fairly quickly.
“Although it may seem counterintuitive, a 50 percent loss requires a 100 percent gain to get back to where you started,” says Anthony Parish, director of Quantitative Strategies at Sage Advisory in Austin, Texas. “Also, behavioral finance has shown that people feel the pain of a loss more than they feel the joy of a similar-size gain.”
As a result, investors who have suffered a big loss can be tempted to take too much risk in trying to recover, making the situation even worse when betting the farm doesn’t work out.
So, what should a small investor do about volatility?
As mentioned, the simplest strategy is to just hang in there, knowing that the broad market has always recovered from downturns. Experts say volatility is like a ringing bell — it rarely stops immediately and often takes about as long to fade as it did to build up.
And investors who don’t panic are often pleased with the result.
“The stock market recovers from dips much faster than most people tend to think,” says John Hagensen, managing director of Keystone Wealth Partners in Scottsdale, Arizona. “For market corrections — meaning 10 percent drops — the market on average has recovered in less than six months. For true bear markets — drops of 20 percent or more — the recovery has been longer, but still less than three years on average. While we don’t know when the bottom will come, we know that historically once it hits, stock have rebounded fast and furiously.”
Weathering the downturn works best for investors who are broadly diversified, owning a mix of bonds and various types of stocks. Some holdings may do well while others are hammered.
[See: 7 International ETFs to Insulate Your Portfolio.]
Since volatile holdings can offer bigger returns over time — think about stocks versus bank savings — they can pay off if they can be left alone for long periods. But volatile assets are not suited to investors who will need their money soon. Parish says investors should avoid volatile holdings that are not expected to beat less-volatile alternatives. Past performance offers a guide to volatility and returns but does not guarantee future results, he says.
So, when volatility threatens, the most important move is to spread your money around before things turn sour. For example, experts recommend reducing concentrated holdings in individual stocks, such as shares in the firm for which you work. It’s very risky to have both your income and investment portfolio tied to the fate of just one company.
“Being over-exposed to a particular sector that falls out of favor, [like] hardware and software in 2000, or financials in 2008, were devastating mistakes,” Newman says. “Being over-concentrated in a particular holding can be equally disastrous.”
While a concentrated position can be dumped all at once, it may be better to trim over a year or two, or longer, so that sales at low prices will be offset by sales at high ones. Unloading a profitable investment over time also spreads out the tax bill.
Investors who are still adding money to their accounts can do the same thing, putting new money into holdings that help diversify the portfolio as a whole. Doing so gradually will allow purchases at low prices to offset ones at higher prices, a process known as dollar-cost averaging.
Volatility is a tougher problem for investors facing immediate expenses, such as those already in retirement. Again, it can be hazardous to make big changes all at once, but it can pay to gradually reduce the portfolio’s exposure to volatility.
It can also pay to reduce fixed expenses such as mortgages and car loans to make it easier to tighten the belt during a downturn. And maybe you don’t’ really need that second home or second car.
Dr. Stephan Unger, assistant professor of economics and business at St. Anselm College in Manchester, New Hampshire, urges investors with looming needs to build up fixed-income holdings like bonds. But since bond values may be undermined if interest rates rise, as many experts expect, he suggests planning to hold bonds to maturity. That way the investor will receive the bonds’ face value even if the price has dipped in the meantime.
Stocks in healthy companies like utilities may continue paying dividends even if share prices drop.
An investor in or near retirement might also consider other income-producing moves, like taking out a reverse mortgage on the home or buying an immediate or deferred annuity.
[See: 7 Important Things to Understand About Annuities.]
Charnet recommends fixed or variable annuities with a living benefit rider, an add-on that guarantees a minimum income for life even if the policy’s underlying assets lose value.
“This guaranteed income stream still allows access to the principal and if properly designed, will allow for the continuation of the income to a spouse for the rest of their lifetimes,” he says.
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How Investors Should Cope with Market Volatility originally appeared on usnews.com
