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5 Rules of the Road for Volatile Markets

After an extraordinarily smooth ride in 2017, the stock market has shown signs of becoming more volatile in 2018. There’s no telling how long it will continue, but some level of volatility is normal.

No market has ever ascended for months in a straight upward line. This is a reality that investors must accept. What concerns investors is the effect on net returns that sustained high volatility might have. Volatility itself doesn’t necessarily mean loss of value, but in the event that it does, protection from volatility is afforded by maintaining a diversified portfolio of high-quality investments. 

All too often, high volatility prompts investors to sell low. Then, attracted to the numbers posted by stocks that are doing well on volatility’s upswing, they often buy high. Of course, this is the opposite of what you want to do. Here is some advice for how you should stay the course during times of volatility. (For related reading, see: Volatility's Impact on Market Returns.)

1. Maintain a Long-Term Focus

Don’t get emotional over volatility. Keep a firm hand on the wheel to steer your financial ship through the storm, knowing you constructed it to take the chop. Maintaining a long-term focus requires you to block out the noise of media reports and have the discipline not to check your accounts every day. It will only bother you and make you less likely to stay the course by giving your stocks time to rebound. Remember: volatility goes two ways. 

2. Stay Diversified

Stay diversified by asset class to balance out ups and downs among different types of assets, with gains counterbalancing losses. The principle asset classes are stocks, bonds and cash (money market). There are numerous others including commodities, real estate and other so-called alternative assets to traditional assets (stocks and bonds).

The benefits of diversification tend to occur in long-term portfolios - in 10 to 15-year periods, according to author and academic Craig Israelsen. Some market periods have been cited as exceptions. But the argument can be made that some of these periods aren’t actually that. For example, 2000 to 2010 has acquired the notorious moniker of “the lost decade” but this characterization tends to reflect an over emphasis on U.S. large-cap equities.

From 2000 through 2009, the S&P 500 Index cumulatively dropped 9.1% and the Russell 1000 Growth Index declined 33.4%. However, Joni Clark, CFA, CFP, points out in an analysis published in Advisor Perspectives in 2010 that various other equity indexes performed quite well during the same period, posting significant cumulative gains. Among these were the Russell 1000 Value Index (up 27.6%), the Russell 2000 Index (up 41.2%), the Dow Jones U.S. Select REIT Index (up 175.6%) and the MSCI Emerging Markets Index (up 154.3%).

“Once you look beyond U.S. large-cap equities and the gloom and doom on Wall Street, conditions really weren’t too bad for stock investing,” Clark concluded in 2010. Investors with equity portfolios that had broad diversification, affording sufficient exposure to these and other indexes that performed well in that decade, would have been able to offset domestic large-cap losses and, depending on their weightings, derive good net returns. (For more, see: Tips for Investors in Volatile Markets.)

3. Maintain Strategic Asset Allocation

Use a consistent, strategic asset allocation - a set dollar percentage of different asset classes, x% in stocks, y% in bonds, etc. - aligned strategically to your goals and risk tolerance. Rebalance your assets periodically to restore your portfolio to your original allocation. When the market is highly volatile, depending on the effects on your portfolio, you may end up rebalancing more often.

Let’s say your set asset allocation calls for 70% of your portfolio to be in stocks and 30% in bonds, and that your stock holdings have appreciated to the point where they now represent 90% of your portfolio’s dollar value. To rebalance, you’d sell some stock holdings and buy bonds to get back to 70%-30%. Maintaining a strategic asset allocation, tailored to your particular needs, helps assure a sound, all-weather portfolio which is good in any market, volatile or smooth.

4. Assure Adequate Liquidity

If you’re relying on your portfolio returns to pay expenses in retirement, or for other reasons, make sure you always have enough cash on hand - preferably in a money market account or another highly liquid, interest bearing (although low) account - to meet your needs. That way, you won’t be forced to sell shares when they’re down. It’s a good idea to set a target for the percentage of your portfolio to maintain in cash and stick to it. The limit will depend on the size of your portfolio and your cash needs.

5. Pay Attention to Economy

Be mindful of where the economy stands in the business cycle to manage the equities in your portfolio. Different market sectors tend to do well or poorly at certain stages of the cycle, which runs from recession to growth and back again. As we enter (or preferably, a bit before) an expansion, you want more tech, materials and consumer discretionary - non-essential goods and services that people can better afford because of wage growth.

In a slowdown, you want to be more defensive, which means consumer staples (things people must buy, like toothpaste). Following these rules doesn’t mean you shouldn’t take advantage of the opportunities that share price volatility may afford. For example, if there are companies you’d like to own but solid analysis tells you they’re too expensive, a sudden dip in the market - as we had in February with an extremely brief 10% correction - can mean opportunities to buy those stocks relatively low, depending on how much the general dip depresses their prices.

I keep a list of such stocks after doing various analyses to determine desirability. When the only barrier to purchase is price and that price is suddenly more attractive for stocks that, according to the numbers have higher real value, one can buy them with reasonable assurance that they’ll bob back up. To be opportunistic in regard equity prices, you need to always be ready to pull the trigger and have a cash available for this without having to sell shares you really should keep.

By following these rules of the road, you can manage your portfolio to withstand potential negative impacts of volatility and take advantage of opportunities that volatility can afford. (For related reading, see: Investment Strategies for Volatile Markets.)