Investing in a Volatile Market

Just because the market has hit a rough patch doesn’t mean you should abandon your investment strategy. Here’s why you should maintain a level head despite the market’s ups and downs.

LEARN MORE: Rebalancing Your Portfolio in a Volatile Market discusses practical implications of market volatility and identifies several steps for investors to consider in assessing and managing risk before rebalancing a portfolio.

When the markets start gyrating, investors may ask whether their portfolios should be adjusted for the added risk that rising volatility can bring. Even the most experienced, hands-on investors might question their long-term resolve and want guidance: should they unload a sagging stock, switch into fixed-income securities, accumulate cash, invest even more at lower prices, or just sit tight and wait for stability to return?

During the last year, as the market has adapted to a host of challenges such as the global credit crunch, surging energy prices and slowing consumer spending, prices have swung farther, faster and more frequently as volatility jumped to near-record peaks. But, rather than being anomalies and statistical outliers, the price swings and accompanying volatility that investors are seeing could be normal, recurring parts of the business cycle.

The Stress of Volatility
According to the late economist Hyman Minsky, the economy is never really in equilibrium but vacillates between stability and instability over time. His financial instability hypothesis — that periods of economic stability and prosperity lead to increased risk-taking, which ultimately ushers in periods of instability as participants seek the efficient use of capital and compete for returns — suggests that volatility is cyclical as well. It rises during higher-risk periods of instability and falls when the economy returns toward stability.

For many investors, the volatility the markets have exhibited during the past year may look extreme, but experts say it likely represents a return to normal levels. Still, the rollercoaster ride has jolted investors, giving them an unwelcome education about what volatility really means, especially because many people were lulled into a false sense of security by the unusually low volatility seen during the early part of this decade. The last time volatility hovered near current levels, the Dow 30 Industrial Index stood at roughly half its current level, so the recent 300-point market swings may seem extreme by comparison.

Stay Focused on Your Plan
Investors faced with unaccustomed volatility and the startling headlines that accompany it have several options: invest more, reallocate, make a move or sit tight. Yet despite unnerving market swings, the reasons for staying true to your long-term plan remain unchanged. Because allowances for a certain amount of overall risk likely were built into your plan at the outset, you might end up trading one kind of risk for another if you overhaul your portfolio in response to market swings.

Since every security has inherent levels of risk and volatility, a welldiversified portfolio is built to reflect the anticipated price swings and levels of risk each individual stock or bond is likely to exhibit. The portfolio’s risk profile also reflects the way these levels of risk and volatility will work together as a whole, according to John Skjervem, chief investment officer for Northern Trust’s Personal Financial Services division. “We take volatility into consideration whenever we analyze a client’s portfolio,” he says. “That way we know what to expect when it comes to volatility and risk, and we can help our investors understand these issues, too. Probably nine times out of 10, any short-term occurrence of volatility is likely to be within the range we expected when we built the portfolio.”

To help examine how a portfolio will react under different levels of volatility, Skjervem and his team employ a powerful software program to create customized asset allocations based on potential outcomes — known as “Monte Carlo” simulations — which can then be further adjusted to match an investor’s specific risk and return objectives. By analyzing a set of variables, the tool helps translate abstract and statistical concepts into real-world examples by demonstrating how adding or subtracting a stock or bond or changing an allocation among asset classes might affect a portfolio three, five and 10 years down the road.

One Risk for Another
Changing your portfolio in response to volatility can end up replacing one kind of risk with another and actually have an exaggerated effect on your portfolio’s balance. This “idiosyncratic” risk results from tinkering with your portfolio — such as selling a “risky” stock in periods of volatility — without examining its effect on your overall portfolio.

Some changes, such as switching among asset classes like stocks and bonds, can carry even greater potential risks during periods of higher market volatility. “A shift from one asset class to another will inherently be more risky than a restructure within the same asset class,” says Grant Johnsey, head of transition management in North America for Northern Trust. “Volatility has greater implications when transitioning among portfolios or markets where the correlation is low.”

When Volatility Hits Home
There are many ways to measure market volatility, such as by tracking daily changes in the Standard & Poor’s 500 Index or by following the Chicago Board Options Exchange’s Volatility Index, or VIX. The VIX, the so-called “investor fear gauge,” rises and falls in tandem with expectations of volatility during the next 30-day period. VIX values greater than 30 generally reflect expectations for a large amount of volatility resulting from investor uncertainty, while values below 20 correspond to less stressful times.

For many investors, the most important gauge and manifestation of volatility comes when they open their quarterly portfolio statements. By maintaining a well-diversified portfolio that takes into consideration your own long-term levels of risk and reward — and not reacting unnecessarily to the inevitable, cyclical market volatility — you may be more likely to meet your investment goals.

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