Volatility is Back – Now What?

By Daniel Sexton, CFP®

Volatility has returned to the markets, fueled by headlines of trade wars, increasing interest rates and rising inflation. Bond prices have declined, and all the domestic market indices are off their highs. This sudden reemergence of volatility has evoked the memories, emotions and fears that shook global markets a decade ago.

So, what do we do? Let’s take a deep breath. That’s it, let it out slowly, and remember this too shall pass. Apologies if I come off glib. Volatility is understandably unsettling, and it can be difficult to keep perspective on the long-term. It’s never easy to reign in emotions. But to be successful investors, we must.

When emotion and uncertainty are present, it’s more important than ever to separate the facts from the noise. If we step back for a moment, we find that the Dow Jones Industrial Average and the S&P 500 indices are currently at levels we saw last November. At that time stock markets had already experienced a stellar year, which illustrates how far they continued to climb.

Unfortunately, market downturns never come with a courtesy “heads up” call or text. However, they are an expected and healthy part of any market cycle. It allows frothy markets to cool and find footing in preparation for the next upturn. Reacting emotionally often leads to significant loss from missed opportunities for investors. In fact, the emotional reaction of investors is partly fueling the recent market volatility. The triple digit swings on the downside is a direct product of investors reacting to the headlines of the day; seeking safety in cash.

During these times we remind clients that markets recover quickly and unpredictably. Missing just a few key days of a recovery can have significant impacts on your portfolio returns. The chart below illustrates this point by measuring the growth of $1,000 against a portfolio that missed some of these top performing days in a year.

History and experience have proven that markets reward discipline. Discipline starts with selecting an allocation (broadly speaking this is the ratio of stocks to bonds) that takes into consideration your needs, goals, and risk tolerance. For our clients, this generally involves a certain amount of financial planning to determine the most appropriate investment mix. While some may position the portfolio simply to achieve the highest returns possible with no other clear objective, this can lead to big bets, missed goals and regrets.

However, allocation alone is not enough. An appropriate allocation must also be diversified to reduce the risk associated with a specific company, industry or sector of the market.  Proper diversification is essential in reaching all segments of the market (large cap, small cap, growth, value, corporate bonds, treasuries, etc.). Under normal circumstances, the individual segments of the market do not gain value or lose value in concert with one another. For example, though our domestic stock market has gone down in value the first quarter of the year, emerging markets have managed a small gain.

Add in a rebalance and trading strategy that systematically shifts money from the best performing sectors to the underperforming sectors (sell high, buy low) while managing the tax impact, you now have a disciplined approach to weather any market condition. But more importantly, a strategy to secure you from dramatic loss.

It is easy to become near sighted in all the instability and confusion of the moment. The truth is that markets in the long run trend up though the wheel seems forever broken. In the last 45 years the markets have endured all kinds of turmoil: recessions, crashes, wars and new paradigms. The chart below illustrates how being disciplined and staying in the market pays off. Illustrated is the growth of $1 from 1970 to 2016 in a diversified index that includes domestic and international stocks, set against the background of some of the most significant market events during that period.

Perhaps the single greatest weapon in an investors arsenal is patience. Aside from those lucky few that are born with great patience, it something that is learned over time from experience.  And as long as we maintain our perspective and stick to our discipline, we can master our emotions to achieve patience and success.