Preparing for Volatility

With the S&P 500 and the Dow up this year 17% and 20%, respectively, individual investors are finally getting more bullish about growth prospects. Usually late to the party, these investors are often looked at by the institutional folks as a contrarian indicator.

After many months of quiet gains in the stock market it's natural that some investors start assuming this will last forever, that we've entered a new low volatility growth paradigm, or something like that. But markets don't go up in a straight line indefinitely. It's during the good times that we need to remind ourselves of market fundamentals, and sometimes even of Newton's law of universal gravitation.

As I have written previously, volatility in the stock market has been very low for most of the past year. The market's "fear gauge", the VIX, has been stuck around a historically low reading of 10 for months, only showing minimal and brief spikes this past spring and summer. As quick as volatility rose it subsided and the stock market barely budged during these short stints of "fear". The futures markets would often indicate a negative opening for stocks, but prices made a habit of grinding higher during the day. This, on top of the market seeming impervious to any number of negative-sounding headlines, has led many to nickname this the "Teflon market".

The S&P 500 has only experienced a daily decline of 1% or more four times this year. This is the fewest number of days for this metric since 1964, still the least volatile year on record. The S&P's average daily change of plus or minus 0.31% is the lowest since then as well.

So, we have a situation this year where stocks have been making repeated record highs on record low volatility. In reality, we haven't seen meaningful amounts of volatility since 2015 and then a rather muted response to Brexit during the summer of 2016. This is leading some commentators to call current market conditions "boring". Well, on one hand I see their point, but on the other hand it's important not to let boredom truly set in as it can easily lead to complacency.

The problem with spikes in volatility, or even just market risk in general, is that it can surprise us if we're not ready for it. And sometimes the surprise can be jarring enough to cause us to wreck our plans by selling investments when we're scared, usually at the worst possible time. Of course, we all know it's best to stick it out through the tough times, but occasionally reminding ourselves of this is a good mental exercise.

I would suggest thinking about market risk in simple terms. First, imagine the stock market dropping by 10% over a short period of time. This would be a technical "correction" and you'd likely hear about it on the news before seeing it on your account statements. If your portfolio allocation is 50% stocks and 50% higher-quality shorter-term bonds, you should expect your portfolio to drop by about half of the market's decline, or 5%. Equate that to dollars for a good approximation of your risk.

Take the math a little further and assume any amount of stock market decline. If your portfolio has XX% in stocks, that's about your exposure to the market's downside. Now, of course a lot more goes into this and much has to do with the kinds of stocks and bonds you own, but you get the general idea. If you go through this simple exercise and the level of risk makes you start biting your nails, then we should meet and review things.

This works in reverse as well. As your allocation to stocks goes up, either on purpose or by accident, your exposure to rising prices does too. This benefits you in good times but can catch up with you pretty fast as prices are falling. This is why we rebalance.

What else can you do when markets are high besides rebalance? Consider turning paper profits into something tangible, like funding home improvement projects, travel, or other goals. Doing so can help when dealing with market risk because it allows you to realize gains, seeing them improve your life instead of just seeing it on paper.

The stock market could very well continue its run for a while as the economy is generally solid and supportive of further gains. Also, declines can and do happen within the context of a continued bull market and they're healthy in the long run. But it's best to get mentally prepared for a market decline of some amount anyway.

It's likely that any meaningful decline will be made a little deeper by a subset of short-term or otherwise uninformed investors heading for the exits at the first sign of danger. These are the late-to-the-party folks I alluded to earlier. Let's not be one of them. Instead, let's try to keep calm, focus on the fundamentals, and stay on track toward meeting our long-term goals.

Have questions? Ask me. I can help.