While volatile markets are nothing new, investor reactions are rarely predictable. Through the first quarter of 2018, investor optimism remained at 17-year high, according to the Wells Fargo/Gallup Investor and Retirement Optimism Index. Sixty percent of investors surveyed were at least somewhat optimistic about the outlook for economic growth, stock market performance and unemployment.
That's especially impressive when you consider that the S&P 500 index fell more than 1 percent 14 times in the first quarter, more than triple the same measure through all of 2017.
Despite shifting markets, more investors remain bullish than bearish, according to the American Association of Individual Investors’ weekly sentiment survey and echoed in Investopedia's own Anxiety Index. But that doesn’t mean they’re capitalizing on the market’s potential. On average, investors hold less than half their assets in stocks, mutual funds and exchange-traded funds, according to AXA and the Insured Retirement Institute.
While volatility brings a certain amount of uncertainty to the markets, it also brings opportunity for investors. Advisors can play a critical part in helping investors to recognize and leverage those opportunities to capitalize on risk.
Put Volatility in Perspective
Financial advisors need to provide a reality check when volatility churns up client fears. “Advisors need to proactively reset investors’ expectations related to stock market volatility,” says Matt Peden, chief investment officer at GuideStone Capital Management in Dallas, Texas. Peden says that, because risk-adjusted returns over the past few years have been abnormal, investors have become accustomed to positive equity returns with little, if any, negative volatility. That isn’t the norm; and investors shouldn’t expect it to be.
“What appears to be a recent spike in stock market volatility is actually rather normal in historical terms,” Peden says. “Volatility doesn’t seem so bad once it’s put in the context of normal.”
Adam Grealish, quantitative portfolio analyst at online investment platform Betterment says it’s important for investors to remain focused on they can control during periods of volatility. “Investors should make sure they’re saving the right amount, taking appropriate risk for their investment horizon and taking advantage of tax strategies that apply to their situation,” all things that an advisor can guide them through.
Reminding investors of the underlying fundamentals of their portfolio is also important in curbing emotional decision-making. “Advisors need to educate clients on the underpinning of the market, which is made up of great companies they transact with on a daily basis,” says Andy Whitaker, vice president of Gold Tree Financial in Jacksonville, Florida.
At the same time, advisors should be aware of where the risks lie. “Corporate earnings have remained strong and are generally exceeding expectations,” Peden says. But rising interest rates and short-term geopolitical risks -- think trade agreements and mid-term elections -- shouldn’t be overlooked.
Focus on the Upside
When volatility sets in, emphasizing the positives can be critical in helping investors overcome their fears. Peden says volatility favors investors who veer towards an active management approach.
“Generally, during more volatile environments, the correlations between individual stock prices are lower,” he says. “This environment is positive for active managers given that the dispersion between winners and losers is much greater.” Peden says that additional returns generated through active management, compounded over a long investment time frame, can add significantly to investor retirement accounts.
Volatility paired with lower market cycles can also benefit investors who are still in growth mode and want to take advantage of dollar-cost averaging, according to Whitaker. “Dividends reinvest at low net asset values for equity accounts, and if the client is making systematic contributions, they’ll buy more shares on the down months," Whitaker says. He says that during periods of higher volatility, advisors should encourage investors who aren’t taking income distributions from their 401(k) or individual retirement accounts to increase their contributions.
Falling share prices also create a buying opportunity for investors who want to increase their equity holdings at a discount. The advisor’s role is to help clients identify which stocks represent the best buys, both for the short and long term.
Highlighting the positive aspects of a volatility streak can encourage investors to stay in the market, rather than selling off assets out of fear. Grealish says it can be riskier for investors to pull out of the market during periods of volatility, instead of riding it out.
“Investors tend to buy after the market has gone up and sell after the market has gone down – the opposite of what you want to do,” Grealish says. “Actual investor returns, in aggregate, underperform a simple buy-and-hold strategy by anywhere from 1% to 4% annually,” and the more changes an investor makes to their portfolio, the more it underperforms.
Look Past Current Volatility
Investors may need a reminder of their reasons for investing when volatility sets in.
“Advisors need to keep retirement investors focused on their long-term plan and success should be measured in accordance to that plan, not the day-to-day movement of the stock market,” Peden says.
He likens investing for retirement to running a marathon. “It’s the long-term preparation and plan that gets the runner through the adversity and difficult times, so they can cross the finish line,” Peden says. “Making short-term adjustments during a race based purely on emotion is detrimental to its outcome.”
That includes shifting into more conservative investments, such as bonds, to escape volatility. While fixed income can seem like a safe investment, bond yields can be unpredictable, especially when a volatile market is accompanied by rising interest rates. Since 1926, stocks have returned an average of 10 percent per year, while government bonds have performed at roughly half that. For investors who are planning for retirement, returns are critical.
“It’s very difficult to predict when equity markets go up or down with much precision,” Peden says. Without equity exposure, most investors will not generate enough earnings for retirement. Rather than reshuffling from stocks to bonds to avoid volatility, retirement investors must “stay the course and maintain equity exposure to ensure they experience the upside of the equity markets.”
The Bottom Line
Volatility is a natural part of market cycles, but it's a concept many investors don’t always fully grasp or appreciate. Educating investors about volatility and its positive aspects is critical in helping them to maintain their footing when the market experiences periodic bumps.
"Investors often think of their equity exposure as their greatest risk, when in fact, their greatest risk is retiring without assets," Peden says.