How to handle stock market volatility
Financial markets are by their very nature volatile. Although many professional fund managers and financial analysts talk about so-called ‘fair value’ for stocks, for much of the time, stocks and shares are in over or undervalued territory. Because of natural swings in the markets, few stocks trade around fair value over short periods of time.
By far the most usual method of dealing with stock market volatility is to buy and hold a stock index Exchange Traded Fund (ETF), a diversified mutual fund, or a diversified portfolio of individual stocks. Further, the purchases are made using dollar cost averaging over time in order to ensure that you buy more when prices are lower, and less when prices are higher.
But what about extreme market volatility? Many people fail to understand that extreme market volatility is not a bullish signal. When a large number of stocks in the market seem to be moving up or down by a significant percentage intra-day, and not due to a one-off event such as a fat finger or a ‘flash crash’, there is generally something more sinister at work.
Assuming that you are holding a reasonably diversified range of stocks in your portfolio, a simple way of determining whether the markets are heading into bearish territory is if the extremes of volatility are affecting all your stocks indiscriminately. In other words, the high volatility is accompanied by high correlation. If even defensive stocks within your portfolio, for example food and pharma companies, are gyrating madly, you probably need to get out your tin hat!
Alternatively, if you have a diversified mutual fund or ETF, and those funds are moving in either direction much more than you would normally expect on a daily basis, that is not a good sign either. What is often confusing as stocks enter a bear market is that sentiment will not be an early indicator. More often than not, sentiment is wildly bullish at the commencement of a bear market, and virtually moribund in the early stages of a bull market.
At such times, you have to bear in mind that prolonged extreme swings in markets are very difficult for anyone to handle. Even the most seasoned professional investors struggle with it. So when faced with ongoing extreme volatility, you need to determine very quickly whether it is simply too challenging.
As an individual investor, you are in the fortunate position of being able to move all your funds into cash. For a mutual fund manager, the choices are generally restricted and bound by the policy of the fund. There will inevitably be a limit to the amount of cash a mutual fund manager is allowed to maintain at any one time. Moving your own funds into cash will clearly not help the mutual fund industry. But the fact of the matter is that during bear markets, cash will always outperform!
And do not forget that index Exchange Traded Funds (ETFs) will usually be the worst performers of all in a bear market, as they are fully exposed. Finally, if you are going to panic, you must panic early. Being the last person to panic will almost certainly have a catastrophic effect on your financial well-being.