For the last several years, stock volatility had become all but a distant memory. The multi-year bull market marched on and stock indices across the globe set new all-time highs with minimal sell-offs that were nothing more than short-lived blips. While investors have welcomed this time period with open arms, it has been anything but a normal environment. Historically market corrections of 5 percent to 10 percent are commonplace, with these “market corrections” most often occurring multiple times in a single year. Early February 2018 was our most recent reminder of this reality as the Dow Jones Index fell over 1,000 points within a single trading session. This lasted correction will most certainly not be the last, so how can we better understand volatility and protect ourselves from it as investors?
When we hear the phrase “markets are volatile” or “volatility has returned” – what does that mean? Volatility occurs when fluctuations in the market impact the cost and returns of securities, making the direction of the overall markets unpredictable. Increased volatility is most visible in times of panic selling. The CBOE Volatility Index, known by its ticker symbol VIX, is a popular measure of the stock market’s expectation of volatility. The VIX is commonly referred to as the fear index or fear gauge for the S&P 500, with a low value indicating market calmness, and high values indicating large price swings, both up and down.
Understanding volatility and its effects on our investment decisions is the first step towards being a successful investor. Although this is much easier said than done, as we know in the heat of the moment our emotions often get the best of us; as investors we have all experienced the unnerving emotions associated with sudden drops in markets. The best way to counter this shift in psychological behavior is to expect it in the first place! Over long durations, markets will experience periods of heightened volatility and by preparing a game plan for these situations in advance you are much less likely to fall victim to your worst enemy: yourself.
The first line of defense from excessive market swings in one’s portfolio is diversification. Diversification can be defined as distributing ones capital amongst a pool of different investments. Holding investments that are affected by different economic and political factors helps ensure they perform differently from one another. Reducing overall portfolio volatility helps provide for smoother and more consistent return profile over time. It is essential, however, that diversification is not treated as a one-time strategy. As markets change and personal circumstances change, there is a need to review a portfolio on a regular basis to ensure it reflects the appropriate risk-tolerance as well as the needs for growth, income and liquidity.
When it comes to volatility, time is on your side. What exactly is meant by that? History shows us that the longer you stay invested the less volatile your overall experience becomes. The ability to build a portfolio that fits your risk-tolerance level will increase your odds of staying invested during those critical times of market instability. Most market downturns are short lived in nature and yes, Annie was right, “the sun will come out again tomorrow.” Having the ability to stick to your plan in times of market turbulence is a determining factor in achieving your long-term goals. As the popular adage often attributed to Benjamin Franklin states, “Failing to plan is planning to fail.”
Professional and experienced long-term investors are able to see volatility for what it truly is, an opportunity. The opportunity to act on one’s plan that has been set in place long before the market environment changed. There is a valuable distinction between stock markets and the actual companies which make them up. Most often the sensationalized headlines of day have little effect on the actual day-to-day operations of individual companies. Most quality companies have survived through multiple recessions, flash crashes, political crises, environmental disasters, heightened inflation and other volatility raising events. Taking advantage of others’ fear during times of disorder has consistently proven to be a winning strategy. This can be done with confidence for those who appreciate that volatility is not always an enemy but a friend as well. As Warren Buffet famously stated, “be fearful when others are greedy, and be greedy when others are fearful.”
Alessandro Sax, CFA, is an Investment Advisor at Milot-Daignault & Sax Team of RBC Dominion Securities Global.