The index that tracks the amount of U.S. stock market volatility — both down-market events and rallies — rose to rare territory in March and has since settled at a plateau higher than any point over the past seven years.
Given ongoing COVID impact, economic and election uncertainty and an additional mix of issues that create unease, volatility seems likely to remain elevated.
We shouldn’t root for no volatility or uncertainty. If that were the case, there would be less risk in investing and therefore less return to compensate for taking the risk. We should, however, understand the role of volatility and our response to it.
As Brian Portnoy wrote in his book, “The Geometry of Wealth”: “Volatility is the emotional cost of achieving the growth we seek. Long-term growth charts of stock and bond markets show remarkable appreciation over time. But such charts don’t give any sense of how difficult it is to hold on to our investments during the many rough patches that occur along the way. The ride matters. To properly set expectations, we have to wonder what the ride will be like. How bad might it get? And am I willing to pay that price?”
To help manage the impact of human nature and psychological reaction to fluctuating financials, the following ideas might provide defense against volatile markets, especially if you feel an urge to sell stocks because of anticipated declines.
Keep long-term goals in mind
Recency bias suggests that you assume what is happening now will continue. It is short-sighted. Keep your big picture decisions focused on long-term goals. Your longer-term goals are likely less impacted by short-term changes in market values than you think.
Separate short-term money from long-term
Money that you will need to cover expenses in the next couple of years shouldn’t be exposed to much potential decline. It should be held in cash or short-term bonds.
Having short-term money set aside allows you to think differently about long-term money, letting it ride through ups and downs that are expected.
Assessing how much risk you are comfortable with is difficult. It is often circumstantial, tied to recent experience. A key understanding needs to be the difference between your tolerance for risk and capacity to take risk. Some people are naturally aggressive and have enough financial capacity to accept larger risks if the potential compensation is attractive.
Others might be tolerant but simply can’t afford to have a significantly adverse financial event at the wrong time.
Different yet, some people have plenty of financial capacity but no tolerance for fluctuating balances.
This might be the most important element of defining who you are as an investor. Whether you are naturally conservative or aggressive, the best investment strategy is the one you can stick with through volatile times.
Have a written investment policy
An investment policy or written strategy should outline your objective for various accounts, define a target weight for stocks vs. bonds or cash, identify how you will evaluate performance and what triggers you will follow to rebalance your investment portfolio.
You will be less likely to deviate from your strategy if it is written.
Decrease the noise
Check your investment performance less frequently. This limits the pressure to react. If you can’t avert your attention, at least put speed bumps in front of your decisions. Apply a wait rule or get a second opinion before you make a change.
Think about the other side
Especially if you own individual stocks, understand that there is a buyer for every seller and a seller tied to every buyer. Why does the person, institution, etc. on the other side of the trade find it more attractive to do the opposite of what you are doing?
Know your biases
When confronted with tough circumstances, conflicting information or uncertainty, the mind will take shortcuts via common biases (loss aversion, overconfidence, illusion of control, etc.). Don’t expect to conquer your biases — it’s hard to thwart human nature — but do understand their impact and, if necessary, talk your thoughts through with a neutral person.
Increase your savings rate
A higher savings rate will take pressure off the investment portfolio to do the heavy lifting required to build and maintain your financial security. Cutting back on savings during volatility is counterintuitive. It puts more pressure on your investments to perform well. Saving more might allow you to reduce the weight of stocks, and therefore the volatility, of your portfolio.
Investment volatility can test your belief system. It’s natural to wonder whether you are making the right decisions amid uncertainty. But the more you follow a quality process, the more confident you should be that, over time, your process will outweigh short-term volatility. You will be able to prepare now and not have to do so much repair later.
Gary Brooks is a certified financial planner and the president of BHJ Wealth Advisors, a registered investment adviser in Gig Harbor.