I thought this would be a good time to talk about how to protect your investments a volatile stock market.
Though mostly MIA for the last several years, market volatility is normal. And making a strong comeback.
The week of February 5, 2018, reintroduced volatility to investors. The media declared this a correction, usually defined by a 10% drop in the index. That declaration came on Thursday, February 8.
On Friday, February 9, stock prices rose enough to move the market out of the correction. At the end of the week, the S & P 500 (largest 500 U.S, stocks) ended down 5.2%.
What should we do in light of this volatility? Change our portfolio? Buy more? Sell more? Do nothing?
Here is what to do
To protect yourself in a volatile stock market, invest the way you always do.
Does this sound too simple? It shouldn't. Sorry. It's not rocket science.
If you think about making changes every time the market becomes volatile, you need to examine whether you have the right investment mix.If you think about making changes every time the market becomes volatile, you need to examine whether you have the right investment mix.
Volatility, though absent for the last few years, is nothing new and is, frankly, healthy. Need proof?
Take a look at this chart showing the 10-year daily closing prices of the S & P 500 index.
As you can see, volatility is very much a part of investing in stocks. So, if you're concerned about the uptick in volatility, it's time to evaluate your portfolio.
Let's get started with the basics.
Types of investments
Here is a review of the various types of investment options available to most people. You likely currently use one or more of these.
These descriptions are the very basics of the investments described. It is by no means an exhaustive list of all the available investments.
Nor is it a comprehensive description of any of these components. Instead, it's a broad overview of the securities that most people use. We will talk about how those fit various strategies later in the post. With that, let's take a look.
Stocks and bonds
Stocks (aka equities) represent ownership interests in companies. They are the riskiest kind of investment. There is no limit to how much you can make or lose in stock investment. If a company goes out of business and you own shares of that company's stock, you could lose all of the money you invested. If it triples in value, your money does the same.
Conversely, bonds (aka fixed income) represent a debt obligation of a company. You give the company your money for a set period for an agreed upon interest rate. Bonds pay interest to you at regular intervals (monthly, quarterly, etc.).When the time for payment is up (the bond matures), you get your original investment back.
Investing in stocks
Stock picking (buy and hold)- This strategy says that if you choose the best companies in the best industries, and keep them for a long time, you will make a lot of money. Investors assume that, through company and industry analysis, they can find the long-term winners in the thousands of publically traded companies listed on the various world stock exchanges.
Stock picking (trading) – In the past couple of decades, trading strategies became very popular. Before 2008, day trading was the newest new thing in stock investing. Trading is nothing more than the buying and selling of shares of stock over short time periods.
Day trading – As the name suggests, is buying and selling of stocks over the course of a day. It's not uncommon for traders to buy and sell the same stock several times during a day. During the market runup before 2008, individuals and companies selling trading strategies were popping up everywhere. The prolific market drops took many of them out of business. Day trades often get executed by computerized trading programs, rather than individuals. Investing strategy? Not so much!
Investing in bonds
Individual bonds (fixed income) – In general, the longer the time before the bond matures, the higher the interest rate. The more extended the holding period, the higher the risk as well. You can buy these bonds through a broker (corporate, municipal, government agency) or, in the case of U.S. Treasury securities, directly from the government at auction.
There are a couple of primary risks in bonds. First is their inability to pay interest or pay back principal when the bonds mature. Second is interest rate risk. If you want to sell your bond before maturity, you receive the market price of the bond. If interest rates are higher than the interest on your bond, the market price of the bond goes down. The reverse is also true. Assuming you own quality bonds (or government guaranteed bonds), holding them to maturity assures you get what they promised.
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These are registered investment companies that you pay to invest your money into the individual stocks and bonds described above. They offer a myriad of investment styles you can choose.
Some funds invest in just stocks or just bonds. Balanced funds invest in both. Within the stock funds, you can select the size of the company (large, medium, small) based on the market value of the companies in the fund.
Other funds invest only in the U.S. Others invest in foreign countries. There are a variety of ways to make investments in foreign countries as well (developed markets, emerging markets, large, medium, small companies). It can be overwhelming.
Investopedia, for whom I am a contributing writer, has lots of great educational articles on investing. Their report, Mutual Funds, What Are They? offers a much more detailed description than what I suggest here.
Investing in mutual funds
Each mutual fund must, by law, distribute a legal document (called a prospectus) to describe the details of the fund's investments and policies. These prospectuses are large documents that only the most detailed oriented investors read (not that there's anything wrong with that). Lawyers love these documents.
Most investors get the information about these funds from summary descriptions, often called fact sheets. These fact sheets offer a look at the portfolio returns, fees, and the investments in the fund. They are a good starting point to learn about the fund.
You can invest in mutual funds directly with the fund company or through a broker or investment advisor.
Exchange traded funds (ETFs)
ETFs are a relatively new player in the investment world. Though there is some debate as to their origin, most people in the U.S. point to the creation of the first S & P 500 ETF by State Street Global in 1993.
From that time until now, assets in ETFs total over $1 trillion. The industry launches new ETFs at a rapid pace. To learn more about the history of ETFs, read this article, A Brief History of ETFs.
ETFs are like mutual funds in the sense that they pool investors money and purchase specific types of securities on their behalf. Unlike mutual funds, ETFs trade on stock exchanges like individual stocks. Fund managers determine share prices at the end of the day based on the closing price of each of the underlying securities. Managers determine a net asset value (NAV) based on the closing prices at the end of each day. Unlike mutual funds, you may pay more or less than the declared NAV. Here's why.
Like stocks, ETFs are priced based on what investors are willing to pay (market price). Though the underlying NAV is determined the same way as a mutual fund, market price determines what investors pay. The market price may be above or below the NAV (referred to as selling at a premium or discount).
Why they are popular
There are two primary drivers behind the success of ETFs.
First is the cost. Most ETFs have much lower expenses than mutual funds. Also, they don't impose additional sales charges. Buying and selling shares of ETFs involve paying a commission (or trading fee) to buy and sell. Managers may tack on a sales charge (as high as 4% or 5%) above the NAV.
Second is the trading. Because ETFs are bought and sold like stocks, many investors prefer them over mutual funds. Unfortunately, traders trade mutual funds the same way they buy and sell individual shares. Though not the way they were intended to be bought and sold, the reality is many people use them as trading vehicles.
ETFs are the investment vehicle of choice for the new digital investment programs now available. Often referred to as Robo advisors, investors using these platforms get preset portfolios of ETFs managed by algorithms. That's a discussion for another day. Suffice it to say; it's another way technology is changing the investment landscape.
Mutual and ETF strategies
In broad terms, there are two types of investing that mutual funds and ETFs employ – active and passive. There is much debate over which method is best. Most of that debate comes from those with vested interests in one or the other of these strategies. Here is a brief description of each.
Active management has been around for the longest time. Fund managers use their research (most of which they claim to be the best) to decide which securities (stocks or bonds) to buy.
The idea is that by researching the companies' financials, industry, management, stock price, etc., managers will only invest in the best companies. The theory is that these companies will outperform the market or the market sector they represent (company size, industry, etc.). I'll talk about what the evidence shows on their success shortly.
Passive management, (often called indexing), as the name suggests, takes a passive approach to stock picking.
This approach was made famous by Jack Bogle and Vanguard. There is a large online community of people who follow this strategy. Called Bogleheads (you read that right) this group are zealots to this investment philosophy. Indexing involves a fund company investing in all of the stocks that make up a particular index (S & P 500, Russell 3000, Barclay's Aggregate Bond, etc.).
These indices are what's called market cap weighted. (OK, that's industry jargon. I'm sorry!). Market cap weighted merely means the companies with the highest stock market value make up a proportionally higher percentage of the index. Rather than trying to beat a particular index, index funds and ETFs strive to match the return of the index. If they are successful, the performance will do just that (less their fees). Index funds are among the cheapest investments available.
There are other types of passive investing besides traditional indexing. One is the Evidence-Based Investment Strategy. Decades of academic market research and real application identify areas of the market that outperform the broader market. This approach is market-based, not securities based.
Those who follow this strategy invest more money in areas where the evidence suggests they will achieve higher expected returns than with traditional indexing. It's the strategy I employ to all of the assets I manage on behalf of clients.
The evidence overwhelmingly suggests that actively managed funds (ETFs or mutual funds) rarely outperform their benchmark index.
For further reading:
From Fortune – Stock-Picking Fund Managers Are Even Worse Than We Thought At Beating the Market
Marketwach.com – This is how many fund managers actually beat index funds
Bloomberg.com – Active vs. Passive Investing
Asset allocation describes the amount of money you have in the various areas of the market. At its most basic, asset allocation means how much money you have in stocks, bonds, and cash. Stocks and bonds describe broad asset classes. Stocks and bonds then get broken down into sub-asset classes for greater diversification,
It might start with U. S. stocks vs. foreign stocks. Foreign stocks might get divided into developed markets and emerging markets.
Within both foreign and U. S. stocks, asset classes get broken down further by separating the size of the companies (large, medium, and small) and if companies are value stocks or growth stocks. There are multiple ways to determine what makes a growth and value stock. I won't get into that here.
Real life example
Here's what asset allocation looks like for a portfolio that is 50% invested in stocks and 50% in bonds (that's the broad asset class mix).
Looking at the chart, you notice that within the 50% of each broad asset class (stocks and bonds), the portfolio shows a further breakdown into sub-asset classes for both stocks and bonds.
Benefits of asset allocation
Asset allocation accomplishes two things:
Diversification – Diversification means having investments in multiple areas of the various markets. The portfolio above shows just that. Not all areas of the market will go up or down at the same time. True diversification means that you will likely be unhappy with some parts of your portfolio during times when other parts are doing well. If everything did the same thing at the same time, you would not be well diversified.
Risk management – The mix of stocks and bonds (broad asset class) largely determines the volatility of your portfolio. Since stocks are riskier than bonds, the more money you have invested in stocks, the more risk your investments will have.
If you aren't sure how to determine your risk tolerance, continue reading. I'll offer some tips below.
More on investment risk
Remember 2008? What would you do if we had another financial crisis? (see the above chart)
The S & P 500 dropped by 37% while emerging market stocks sank over 50%. A 10% drop in light of these returns seems meaningless, doesn't it? However, if that still keeps you up at night, you may need to make changes.
Behavior finance defines some behavioral traits that cost investors money in lost returns. One of those is recency bias. Recency bias posits that recent, more current information, is more valuable than information about events in the past. How does that translate to investing?
We are now almost ten years from the financial crisis of 2008. The market has been on an enormous run with little interruption. A byproduct of this long run is that investors forget about the events of 2008 and take on more risk by investing more in stocks. It's the “this time is different” attitude. It's also the FOMO virus that infects so many people. Don't let yourself fall into the trap.
What to do if you have too much risk
As Mike Piper points out in his excellent article Worrying about Market Declines and High Valuations, if a 10% drop in the market keeps you up at night, you probably shouldn't invest in stocks. He points out that since they began their recent bull market run (early March 2009), stocks returned close to 400%! According to this S & P 500 return calculator, the S & P 500 returned 336.404% (including reinvested dividends) from March 2009 to February 2, 2018.
In my previous post, How to Survive a Market Crash, I talked about your portfolio passing the stomach test. So, when you watch your portfolio value drop if your stomach gets queasy, it's time to reduce the amount of money you have in stocks. There are tools to help you measure this risk. If you work with a financial advisor, he/she should have tools to help.
Tools to determine risk
Personal Capital offers many free financial software tools to help you. If you manage your investments, one or more of your mutual fund companies likely have portfolio analysis tools you can use. Because no one likes volatility when investing. Therefore, if the dislike turns into fear, it's time to make changes. Make those changes is sooner, rather than later.
I'm not talking about a wholesale selling of all of your stocks. That would not be prudent. I am talking about reducing the amount of money in equities. How much? A good measuring stick would be to see how the portfolio would have performed in the crisis of 2008. As a result, when you look at that drop in dollar value, you get a sick feeling (the stomach test), lower your risk until that queasy feeling goes away.
Doing that will help you get through the next significant downturn without fear and the temptation to sell stocks at the worst possible time.
Don't fear market volatility. It's healthy and part of what keeps markets working. No one can predict when markets move up or down or by how much. Us what you've learned here to evaluate your portfolio risk before markets go crazy. Doing it during times of extreme volatility can COST YOU A LOT!
So, with that in mind, take the time to examine your portfolio. Make sure it passes the stomach test. If it doesn't, consider taking some risk off the table by reducing how much you have in stocks. The evidence clearly shows that staying invested in a properly diversified portfolio that captures returns offered by the market is a winning strategy. Rebalancing your portfolio can help you stay on track. Rebalancing keeps you from making rash decisions during stressful times in the market.
Please, let me know if this was helpful by commenting below.
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