How to navigate market volatility

By Jason R. Friday, CFP®, MPAS®, RICP®, CMFC, Head of Financial Planning | Citizens Wealth Management

Reviewed by Jamie Viceconte, Head of Investment Product | Citizens Wealth Management

Markets don’t go up in a straight line. Prices can rise and fall sharply over short periods of time in response to changes in the macroeconomy, government policy updates, or investor sentiment. This is known as market volatility.

Understanding how volatility works can help you find ways to manage risk more effectively and make informed investment decisions.

What is market volatility?

Market volatility refers to the size and frequency of price changes of specific securities or market indices. The price of investments fluctuate as investors buy and sell. Low volatility indicates more stable, gradual price movements. High volatility indicates larger price swings.

For example, the S&P 500 tracks the stock prices of 500 of the largest companies in the United States. The S&P 500's value typically changes by less than 1% daily. However, much larger price changes are more likely during periods of high levels of market uncertainty. There have been times when the S&P 500 has gone up or down by more than 10% in a single day — an example of extreme market volatility.

It can feel stressful to see your portfolio balance swing up and down over a short time frame, even if the market moves higher over time. Volatility sometimes leads to emotional decisions that hurt returns, like buying only after markets have risen or selling everything in fear after a market correction or crash.

What is the VIX, and how does it measure volatility?

The Volatility Index, also known as the VIX, measures how investors feel about the stock market's future performance. Its value is based on the demand for options contracts on the S&P 500 over the next 30 days. Options give an investor the right to buy or sell a security at a set price in the future. When market volatility is high, options can increase in value given the higher expectation of a significant change in the price of the underlying security.

Also known as the fear index, the VIX provides a number to measure the average demand for these options. Typically, when investors are worried about a possible market downturn, demand for these options goes up and so does the price of the VIX. The higher the VIX, the more investors expect future volatility.

If the VIX is between 0 and 15, investors expect the market to remain steady over the next month. If the VIX is over 30, investors are expecting significant price swings. It is important to note that the VIX represents expectations of higher market volatility by professional investors. Just because the VIX has gone up doesn't necessarily mean that the market will fall further.

What causes market volatility?

Certain conditions make market volatility and larger portfolio swings more likely. Here are some common scenarios:

• Disappointing economic developments. Investors track how the economy and companies are doing through the release of data like corporate earnings, hiring and overall manufacturing output. If the results meet expectations, markets tend to be stable. Concerns with market levels and consequent market volatility may increase if there are surprises, like companies earning less than expected.
• Sudden government policy changes. Government policy impacts the stock market. When policy shifts happen quickly or unexpectedly, it can add to market volatility. For instance, the Federal Reserve raised interest rates aggressively from 2022 to 2023 to combat inflation. The frequency and amount of these hikes led to sharp market reactions as investors reassessed their impact on the global economy.
• Global strife and disasters. Wars, terrorist attacks, oil shortages and major weather events can disrupt the stock market and create market volatility. The COVID-19 pandemic, for instance, resulted in significant market volatility. Equity markets fell dramatically at the start of the pandemic before rebounding to record highs as pandemic concerns dissipated and the economy recovered.
• Prolonged inflation. Inflation measures the changes in prices of goods and services over time. When inflation is low, the economy and markets tend to be more stable. When inflation is high, markets usually become more volatile as rising prices can disrupt companies and the macroeconomy.

How to deal with market volatility

While you can't completely avoid market volatility, there are strategies that can help to mitigate risk and prevent emotional trading decisions during tough market conditions.

Focus on your financial plan

Market ups and downs can be unsettling, but reacting emotionally to short-term market swings can derail your long-term plans and goals. This is why having a financial plan is so important.

Your financial plan serves as the foundation for your investment strategy, providing clarity on your objectives and the reasons behind your choices. It should anticipate market volatility, ensuring that your investment strategy remains resilient even during uncertain times. This can help you stay aligned with your long-term financial objectives and avoid making costly mistakes.

Consider dollar-cost averaging

Dollar-cost averaging means investing a specific dollar amount at regular intervals, often monthly, regardless of market conditions. This steady approach helps reduce the impact of short-term market volatility by avoiding the temptation to make emotional investment decisions. It also removes the pressure to try to time the market.

Since you're committed to investing the same amount regularly, you won't invest more during a market boom or sell your investments when markets are correcting. You're taking reactive decision-making out of the picture and letting long-term market trends work in your favor.

Build a balanced and diversified portfolio

Proper asset allocation is all about creating the right balance of investment assets based on your risk tolerance, time horizon and objectives. The 60/40 portfolio, which consists of 60% equities and 40% bonds, is a common example of asset allocation. Equities tend to have a higher potential for growth but come with more volatility, while bonds and cash can help provide more stability.

If you're many years from retirement, you have more time to invest through market swings and can take more risk in your portfolio. If you're closer to retirement, however, you may want to shift to a more conservative asset allocation.

Diversification is also important. Spreading your investments across and within asset classes, industries, and geographies should help to further reduce risk and volatility in your portfolio. If one sector of the market experiences a downturn, other sectors may continue to perform well, smoothing out your overall returns. Index funds that track broad market benchmarks, like the S&P 500, are a simple, cost-effective way to provide market diversification. Fund allocation models provide more diversification, further muting market volatility, by including international equities and bonds.

Explore tax-loss harvesting

During periods of market volatility and downturns, you may find opportunities to trim your tax bill by utilizing tax-loss harvesting. Investments in your taxable brokerage account that have lost value since purchase can be candidates for sale. Realized losses can be used to offset gains in your portfolio to reduce your tax bill.

If your losses are more than your gains, you can claim up to $3,000 in losses as a deduction against your ordinary income taxes.

To maintain your market exposure, you can move your money into a different but somewhat similar investment. For example, you could sell shares of an S&P 500 mutual fund for a loss and then buy shares of a Russell 1000 fund, another fund that tracks the stock performance of large capitalization U.S. companies. This gives you an immediate tax deduction while maintaining a similar portfolio if the market rebounds.

Get professional guidance

You don’t have to navigate market volatility alone. A financial professional can help you make sense of what’s happening, review your investment strategy, and ensure it still aligns with your long-term goals. Whether you’re feeling anxious or just want a second opinion, getting professional guidance can provide clarity and confidence when you need it most.

Managing market volatility

Market volatility can lead to uncertainty, anxiety or a feeling of losing control for investors. Without a plan and proper guidance, people may make reactive investment decisions that negatively impact their long-term financial goals.

But market volatility is part of investing. With the right strategy and financial plan, not only can you figure out how best to manage your reactions to volatility, but you can also find ways to take advantage of these conditions for better portfolio growth.

Looking for more advice on how to prepare your portfolio? Request a call from a Citizens Wealth Advisor* to help you prepare for the road ahead.

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