How to handle stock market volatility is a common question among investors especially during periods of big market declines.
It can be unnerving for investors, often triggered by emotions of fear and concern, partially if they occur unexpectedly or in a very brief period of time. However, such declines are historically not unusual.
Market volatility fluctuates based on the business cycle and due to external events that heighten risk and threaten growth. It is a normal feature of markets that investors should expect. In fact higher volatility corresponds to a higher probability of a declining market, while lower volatility corresponds to a higher probability of a rising market.
Continue reading to explore how to handle stock market volatility.
How to Handle Stock Market Volatility: What is Volatility?
Market volatility is the frequency and magnitude of price movements, up or down. The bigger and more frequent the price swings, the more volatile the market is said to be.
Volatility can be measured using the standard deviation, which signals how tightly the price of a stock is grouped around the moving average. When prices are tightly bunched together, the standard deviation is small. When the prices are widely spread apart, the standard deviation is large.
Standard deviations are important because not only do they tell you how much a value may change, but they also provide a framework for the odds it will happen. Plus, 68% of the time, values will be within one standard deviation of the average, 95% of the time they will be within two and 99.7% of the time they will be within three.
Traders calculate standard deviations of market values based on end-of-day trading values, changes in values within a trading session, intraday volatility, or projected future changes in values.
How to Handle Stock Market Volatility: The VIX
Casual market watchers are probably most familiar with the VIX method, which is used by the Chicago Board Options Exchange’s Volatility Index. The VIX, also known as the “fear index” is the most well-known measure of stock market volatility. It gauges investors’ expectations about the movement of stock prices over the next 30 days based on S&P 500 options trading. The VIX charts how much traders expect S&P 500 prices to change, up or down, in the next month.
Historically, the normal levels of VIX are in the low 20s, meaning the S&P 500 will differ from its average growth rate by no more than 20% most of the time. The VIX, however, has been lower over the last 10 years.
This is most likely due to the long-term bull market over the past decade, which has created complacency among investors. When markets get spooked, it is typical to see VIX temporarily print in the 40s and 50s as traders rush to purchase protections for portfolios. VIX values went as high as 82.69 in March 2020 as economic anxiety about the COVID-19 pandemic began to set in.
How to Handle Stock Market Volatility: How Much Market Volatility Is Normal?
Markets frequently encounter periods of heightened volatility. As an investor, you should plan on seeing volatility about 15% from average returns during a given year. In one in five years, you should expect the market to go down about 30%.
Most of the time, the stock market is fairly calm, interspersed with brief periods of above-average market volatility. Stock prices aren’t generally bouncing around constantly, there are long periods of not much excitement, followed by short periods with big moves up or down. These movements skew average volatility higher than it actually would be most days.
In general, bullish markets tend to be associated with low volatility, and bearish markets usually come with unpredictable price swings, which are typically downward.
How to Handle Market Volatility: A Few Approaches
There are countless ways you can react to the up-and-down activity of your portfolio. But one thing is for certain, experts do not recommend panic selling after a big market drop.
In the periods since 1970 when stocks fell 20% or more, they generated the largest gains in the first 12 months of recovery. So, if an investor hopped out at the bottom and waited to get back in, that person would have missed out on significant rebounds, and might have never recovered the value they lost.
For tips to handle market volatility, try one of these approaches:
How to Handle Stock Market Volatility: Rebalance Your Portfolio, as Necessary
Because market volatility can cause sharp changes in investment values, it’s possible your asset allocation may drift from your desired division after periods of intense changes in either direction.
During these times, you should rebalance your portfolio to bring back in line with your investing goals and match the level of risk you want. When you rebalance, sell some of the asset class that has shifted to a larger part of your portfolio than you’d like, and use the proceeds to buy more of the asset class that has gotten too small. It’s a good idea to rebalance when your allocation drifts 5% or more from your original target mix.
You also may want to rebalance if you see a deviation of greater than 20% in an asset class. Suppose you are aiming for emerging market stocks to be 10% of your portfolio. After a big market swing, you discovered that emerging markets were more like 5% or 15% of your portfolio. In such an instance, your holdings could be rebalanced.
How to Handle Stock Market Volatility: The Long-Term Plan
Investing is a long-haul endeavor, and a well-balanced, diversified portfolio, was actually built with periods like this one in mind. Investors who need funds in the near future shouldn’t be in the market, since volatility can affect the price at which an investment can be sold in a hurry. But for long-term goals, volatility is part of the ride to significant growth.
Volatility is the price paid when investing in assets. Since investors want the best chance of reaching their long-term goals, the cost of doing so should be weighed.
How to Handle Stock Market Volatility: Emergency Fund
Market volatility isn’t a problem unless one needs to liquidate an asset, since an investor could be forced to sell assets in a down market. That’s why having an emergency fund equal to three to six months of living expenses is especially important for investors.
Setting aside an appropriate emergency fund so investors do not have to worry about selling down investments to fund cash needs during periods of market volatility is optimal and creates peace of mind.
If an investor is close to retirement, planners recommend an even bigger safety net, up to two years of non-market correlated assets. That includes bonds, cash, cash values in life insurance, home equity lines of credit and home equity conversion mortgages.
How to Handle Stock Market Volatility: Consider Market Volatility an Opportunity
It may help investors mentally deal with market volatility to think about how much stock they can purchase while the market is in a bearish state. Particularly with stocks that have been strong for the past few years, periods of volatility actually provide a chance to purchase these stocks at discounted prices.
For instance, during the bear market of 2020, investors could have bought shares of an S&P 500 index fund for roughly a third of the price they were a month before, following a decade-plus of consistent growth. By the end of 2020, the investment would have been up about 65% from its low and 14% from the beginning of the year.
How To Handle Stock Market Volatility: The Bottom Line
The higher level of volatility that comes with bear markets can directly impact portfolios, while adding stress to investors, as they watch the value of their portfolios plummet. While it is tempting to give in to that fear, try to stay calm.
With history as a guide, those who are patient and disciplined have done very well. Even considering periods like the Great Recession and times of large volatility, the U.S. stock market has provided an average annual return of about 10% each year for the long term.
Adam Johnson writes for www.stockinvestor.com.