By Jason R. Friday, CFP®, MPAS®, RICP®, CMFC Head of Financial Planning | Citizens Wealth Management
As Head of Financial Planning, Jason is a strategic partner who is responsible for developing the strategy, managing the planner teams, and coordinating personal financial planning activities across Citizens Wealth Management to help clients navigate and grow in changing circumstances.
Investing is a tradeoff between risk and reward. If you put all your money in the bank, you'll earn a guaranteed interest rate and never worry about losing money.
If you invest in the stock market, you can earn a much higher long-run return, but the value of your portfolio will go up and down constantly. This is known as market volatility. Understanding this concept can help you find ways to manage risk and make better investment decisions.
Market volatility measures the size of price changes for an investment and the frequency of those changes. The price of investments adjusts daily as investors buy and sell, but the size and frequency depend on the investment's volatility.
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 possible during periods of high market volatility. There have been times when the S&P 500 boomed or crashed by more than 10% in a single day.
It can feel stressful to see your portfolio balance swing up and down dramatically, even if you get to the same place by the end of the year. Volatility sometimes leads to emotional decisions that hurt returns, like buying too much of an investment on a hot streak or selling everything in fear after a crash.
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 let people buy or sell a security at a set price in the future regardless of the actual market price. When market volatility is high, options are more valuable because there is a higher chance of making a significant profit from a big price swing.
Also known as the fear index, the VIX provides a number to measure the average demand for these options. 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 expect massive swings. Keep in mind these are predictions by professional investors. Just because the VIX has gone up, it doesn't necessarily mean that the market will crash.
Certain conditions make market volatility and larger portfolio swings more likely. Here are some common scenarios:
While you can't completely avoid volatility, there are strategies to reduce the risk for your portfolio, boost returns and prevent emotional trading decisions during these tough market conditions.
Dollar-cost averaging means investing a specific dollar amount per month to purchase more shares. You invest the same amount each month no matter what the market is doing. Dollar-cost averaging helps to counteract market volatility because you don't change your behavior each month based on market conditions.
Since you're committed to investing the same amount, you won't get caught up overinvesting during a boom and selling everything when markets are down. You're taking reactive decision-making out of the picture and letting the market do what it does while you simply ride along. Most often, this approach nets out positively.
Proper asset allocation finds the right balance of investments based on your risk tolerance and objectives. Stocks have more volatility while bonds and cash have less.
Check your allocations regularly to make sure your portfolio still matches your goals. If you're many years from retirement, you have more time to wait out market swings and can take more risk in your portfolio. If you're closer to retirement, however, you may want to shift to conservative assets.
Diversification is essentially the concept of not putting all your eggs in one basket. Spreading your money across multiple investments in different industries may be able to reduce risk and volatility in your portfolio.
For example, if oil prices skyrocket, it would be good for oil companies and bad for car companies and airlines. If oil prices fall, the reverse is true. By having both stocks in your portfolio, you avoid major swings and are set up to have earnings growth in both scenarios.
An easy way to increase diversification is to invest in an index fund that mirrors the entire market's overall performance. You might, for instance, buy a mutual fund or exchange-traded fund (ETF) that tracks the value of the S&P 500. On the whole, the stock market generally has much less volatility than a single stock.
Consider how you're investing your portfolio. You can have taxable, tax-deferred and tax-free accounts. Taxable accounts are those where you owe taxes every year, like a regular brokerage account.
Tax-deferred accounts, such as traditional IRAs or 401(k)s, delay taxes until retirement. On the flip side, tax-free accounts, like Roth IRAs or Roth 401(k)s, do not charge taxes in retirement.
While creating a tax-efficient asset allocation does not directly help with market volatility, it does help with your overall after-tax return. By spreading your money across various accounts, you can maximize tax savings today and in retirement.
During periods of market volatility and downturns, you may find opportunities to trim your tax bill by using tax-loss harvesting. Look for investments in your taxable brokerage account that have lost value since your purchase and consider selling them during the downturn for a tax deduction.
You then use these capital losses to offset the taxes owed on your investment gains. 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.
As part of tax-loss harvesting, 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 U.S. companies. You get an immediate tax deduction while maintaining a similar portfolio for when the market rebounds.
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.
A financial planner can be a valuable resource to help you with your financial goals.
This strategy can be beneficial in the short-term, but it’s important to work with a financial advisor to reach your financial goals.
A financial plan is a roadmap for your financial life. A solid financial plan could keep you on the right track designed to match your goals.
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Citizens Wealth Management does not provide legal or tax advice. The information contained herein is for informational purposes only as a service to the public and is not legal advice or a substitute for legal counsel. You should do your own research and/or contact your own legal or tax advisor for assistance with questions you may have on the information contained herein.
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