Any time there is market volatility or economic uncertainty, investor fear starts to rise. It seems no matter where you look, a news outlet is telling you “it’s the worst day since X,” or “we’re witnessing the largest weekly drop since Y.” The problem is, while these outlets are creating fear and/or concern, they generally aren’t taking the time to give actionable advice on what you should be doing. Here are four actionable strategies to consider as we continue to see volatility. In closing I’ll give you advice on preparing for the next big market move:
- Readdress your risk tolerance
- Deploy additional capital
- Have a plan
Readdress Your Risk Tolerance
Risk tolerance is the amount of risk an investor is comfortable taking or the degree of uncertainty an investor can handle. Generally, a higher risk tolerance results in a higher weighting in equities – meaning more of the account(s) will be invested in stock versus bonds. An investor with a lower risk tolerance will often have a higher weighting in non-equity assets such as bonds, cash, or cash equivalents.
While this may seem clear, in practice it’s rarely what actually happens, especially coming off a 11-year bull market. From March 1, 2009 to February 19, 2020, the S&P 500 was up more than 479%. There’s an old saying – the market is driven by two emotions: fear and greed. When there is volatility, there is generally fear. When we experience a long bull market, there is generally greed. When there isn’t a plan in pace, succumbing to these emotions can profoundly harm an investor’s portfolio’s performance.
So, how do you avoid succumbing to those emotions? One way is by understanding your tolerance for risk. Whether you’ve taken a risk-tolerance questionnaire or you have a general idea of your tolerance for risk, you shouldn’t deviate from it. As markets rise, investors often want to be more aggressive than they normally would be otherwise. On the flip side, when markets fall, investors generally want to be more conservative than they otherwise would be to minimize the downturn in their portfolios. Since no one knows what the market will do on a daily, monthly, or yearly basis, you should invest based on your own risk tolerance.
Rebalancing is the process of placing trades in an account to realign the weightings of the assets. For example, let’s assume your original target was 50% stocks and 50% bonds. If stocks have performed well over time and you haven’t rebalanced, your allocation could be 70% stocks and 30% bonds. In this example, you would sell some of the stock positions and add to the bonds to get the target allocation back to 50/50.
When you rebalance, there are two forces at play. First, in an up market, an investor is locking in gains realized within the portfolio. A gain isn’t truly realized until a sale has been made. As an example, let’s say you own a stock investment and bought it on January 1 for $10,000. On July 1, your investment grew to $15,000 and by December 31 it dropped to $9,000. Had you sold the position on July 1, you would have realized a 50% gain. If you sold on Dec 31, you would have realized a 10% loss over the prior 12-months.
If your target allocation was 50% stocks and 50% bonds and you rebalanced on July 1, you would move $2,500 of the $15,000 from stocks to bonds. This would give you a new weighting of $12,500 in stock and $12,500 in bonds, or a 50/50 allocation.
The second force at play is buying stock positions with bond money in a down market. In this example, let’s assume you had a 50/50 allocation between stocks and bonds. Due to the market pulling back, your current allocation is 30% stocks and 70% bonds. To get back to your target allocation, you would sell a portion of your bond investments and increase your stock positions. By rebalancing, your portfolio gets back to the proper 50/50 allocation. In this scenario, you are potentially selling positions that haven’t dropped as much, or may be up, compared to the stock positions and buying stocks at a discount from where they were prior to the market pulling back.
Deploy Additional Capital
This process can come in many forms. I’ll discuss three scenarios: dollar-cost averaging (DCA), systematic investing (SI), and buying the dip in the sections that follow.
A Case for Dollar Cost Averaging and Systematic Investing
In a DCA investment strategy, an investor divides the total amount to be invested into periodic purchases in an effort to reduce the impact of volatility on the overall purchase. The purchases happen at regular intervals and are usually in the same dollar amount. The reasoning behind this strategy is to remove market timing in order to make purchases of investments at their best prices.
In the table above, by using the DCA strategy and hypothetical prices, the investor makes purchases on a monthly basis and reduces the average cost per share from $10 to $8.50.
SI and DCA are somewhat synonymous. With SI, an investor makes regular equal payments into an investment. By using this process, the investor may get the long-term advantages of DCA. The chart below shows the impact of SI over a six-month time period, with a starting value of $10,000 and hypothetical returns:
Buying the Dip
While this is not the preferred method of investing, it’s somewhat common. Buying the dip is the process of adding money to your portfolio when the market takes a downturn. It’s not preferred because no one knows where the market will head on any given day, how long it’ll go down, and where the bottom will be. Investors will generally try to time the market and make a purchase when they “think” they will get the best price. In the hypothetical scenario below, we know the outcome, so it’s a lucrative proposition. However, unless you have 20/20 hindsight or extreme luck, this scenario and the returns are highly unlikely.
Have a Plan
It’s important that you have a plan for positive and negative outcomes. What will you do if the market goes up or down by x%? Will you add to your portfolio, panic, buy/sell, or stay the course? What is the threshold, change in value, or percent that will cause you to make a change?
You must understand your tolerance for risk and readdress it at regular intervals. As you age or have major life changing events, it’s likely your tolerance for risk will change as the markets go up and down.
Your plan should include knowing when you or your advisor will rebalance your assets. Will you rebalance on a set schedule, when there is a change in target allocations, or a combination of the two?
You should set up systematic investing and don’t modify your plan based on what the market is doing. If you do modify your SI, have a reason other than a ”gut feeling.”
Finally, don’t try to time the market. Deploy additional capital only after you’ve thought through how and when you’ll do it.