Volatile markets can be stressful. Strategic planning can ease the impact.
The market is up one day, you feel good. The market is down the next, you feel stressed. The emotions of greed and fear, the driving forces behind investing, can create havoc without a good understanding that volatility creates opportunity. ”Be fearful when others are greedy and greedy when others are fearful.” Warren Buffet’s philosophy takes discipline and I assure you that a good understanding aids in that discipline.
The longest bull market American business history came to a sudden halt in February 2020. Then just as suddenly bounced back and started setting record highs again. Year-to-date in 2021 has been a wild ride with astonishing government spending that has no end in sight as the current set of politicians in the majority believe that government can fix anything by spending money that they do not have. We’re not here to take sides on politics. Our politics is the U.S. Constitution, not any party or personality.
The novel coronavirus of the past year or so, the change in political direction that the U.S. has taken and the high probability of inflation increases in recent weeks exemplifies why we should always prepare for the unexpected in a way matched to our goals. Let’s look at some strategies to help.
Before investing you should establish an emergency fund of about six months expenses. If you haven’t yet, do so now then return to funding your investments. The last thing that you want to happen is to be forced to sell securities when the market is down to cover bills should your income be disrupted.
The money should be held in a cash position like a money market fund or savings account. Protection of principal is your goal. Put it in a separate account earmarked for its special purpose as opposed to holding it in a checking or investment account with other money. Some people even put cash or a cashiers check in a safety deposit box as an emergency fund.
Asset allocation, part of Modern Portfolio Theory, is the process of diversifying your portfolio in a way consistent with your goals, risk tolerance and time horizon. Historically, when stocks decline bonds go up and vice versa. This is called negative correlation. The goal is to mute the volatility as much as possible. There have been, however, a few instances when stock and bonds both went down; 1973-74 bear market, 1993 and 2008.
Studies have shown that mixing commodities into an asset allocation has reduced volatility. Commodities by themselves are highly volatile. But, since they are non-correlated to the movements of stocks and bonds, historically adding such to a portfolio reduces the ups and downs from month to month. We do not recommend dealing directly in commodities, but you should be able to find a good commodities ETF based on a popular index or a mutual fund dedicated to the sector. Real estate and other alternative assets may serve the same effect.
Dollar Cost Averaging
By contributing to your investments monthly, volatility is your friend. Dollar cost averaging is a practice of purchasing an equal dollar amount of a security at regular intervals regardless of price. Let’s say you’re investing $1000 per month into an exchange traded fund, for example. If the price per share is $50 when you start, you’ll buy 20 shares. When share prices go down you buy more shares automatically. For this example, let’s say that the share price falls to $40, you’ll buy 25 shares that month. No luck is needed to try to hit the perfect time to buy.
Conversely, if share prices were to hit $55 you would automatically buy fewer shares, 18. Here’s an important side note, 1000/55=18.1818 shares, but you can’t buy fractional shares of an ETF or a stock. You can buy fractional shares of a mutual fund.
After you read this, run out a few mock scenarios of a year or so of investing with a constant dollar amount and changing share prices. What you should discover is that the average cost of shares, what you would have actually paid, is lower than the average price of shares, the market price asked. Since we cannot predict which direction a share price will go, this is an attractive way to invest regularly.
Opportunity to Double Down
What happens if you invest in a stock or mutual fund and it starts going down. Some people sell immediately to cut their losses thinking that they made a bad call. Some people are willing to hold it until the price goes back up and they break even, then sell and forget it. But, when prices go down it’s really an opportunity, especially if you already believe in the security enough to have bought it the first time. When I was a practicing stock broker my clients would simply buy more.
If we believed in a security at $50, we loved it at $40. When you double down, buy an equal number of shares of the same stock, you get back to the break-even point faster. When you buy the same number of shares at $40 as you did at $50 then the security only needs to make it back to $45 for you to hit break-even.
Tax Loss Harvesting
I write often on taxes related to investing. I recommend that you read a few of those blogs for information on tax management. Here, I’ll summarize tax loss harvesting as it relates to market volatility. Currently, tax laws allow us to reduce taxable capital gains by our capital losses. The wash-sale rule prohibits investors from trading in the same or “substantially identical” security 30 days before or after the sale of a security at a capital loss. Otherwise, the IRS may disallow your tax write-off.
Selling securities at a loss and reinvesting into something that is not substantially identical is a strategy to take advantage of market volatility. Market volatility often moves the entire market, so a security that is similar to the one you sell may well have gone down too and both may go back up as well. This is a tax strategy, not an investment strategy. Do your homework and check with your tax advisor.
Asset allocation models are to be rebalanced regularly, usually quarterly, bringing the model back to its original percentages. Since asset classes don’t all move in the same direction at the same pace a portfolio can become out of balance. Assets are sold from the classes with percentages higher than the models calls for and used to buy assets in the classes with lower percentages thereby bringing the assets back in line with the model. It’s a planned “buy low, sell high” event. In times of excess volatility the percent that an asset class represents can become exaggerated. In an event of sudden increased volatility in between regular scheduled rebalancing, it may do you good to do an unscheduled reallocation to hit a bonus buy low, sell high.
Historically, when the stock market goes down people turn to dividend stocks to earn something while waiting for growth to return. Obviously, more buyers would slow the decline of those stocks during a volatile sell-off. Most companies pay dividends quarterly. An added bonus happens when you are reinvesting your dividends. You’ll earn more dividends each quarter as you accumulate more shares. You’ll get paid to wait for the recovery and have more shares with which to recover.
There are benefits to volatility when it’s managed properly. Take a look at your portfolio and strategy to make any needed adjustments. The volatility in the markets and the disruption to our economy that we’ve experience recently is temporary. Drop me a message here and let me know what your biggest concerns are about market volatility.
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