Don’t panic: Why you should ride out the waves of market volatility

If you look at the New York Stock Exchange’s advance/decline line between December 2018 and February 2019, you’ll see a dramatic V shape. In periods of volatility like this, it’s a challenge not to react to the short-term market swings and remain true to your long-term investment goals. But if investors want greater returns, risk is a part of the process — the fleas that come with the dog, if you will. Here are some recommendations for riding out the waves of a volatile market:

Put it into perspective
According to the WSJ Market Data Group, in 2017 the Dow Jones Industrial Average and the S&P each experienced the smallest absolute daily percentage change since 1964. With such a low level of volatility, any sort of uptick last year was going to surprise investors. And indeed, the fourth quarter of 2018 was a wake-up call for some. It's not that the volatility of 2018 was abnormal, it's that we became accustomed to the tranquility of the preceding years. The stock market’s standard deviation last year was actually below the average of the past 60 years. But factor in the all-time high the market reached last September, and it’s understandable that such a drastic drop in a short period of time would be startling.

Stifle your emotions
In my experience as a portfolio manager, market volatility can bring out the worst in people when it comes to managing their investments. When the market takes a downturn, they tend to become myopic. A common pitfall is to start thinking of investment accounts like checking accounts, equating market losses with actual spending. With this intense focus on short-term results comes the risk that they will abandon their long-term financial plan.

The best way to combat this reaction is to take emotion out of any financial decisions. There’s a difference between selling when things are bad and repositioning. If you sell near the bottom, as many people did back in 2008-2009, you lock in negative returns without any recovery potential. And buying back in when the market is “good” again can be a mistake — it’s often the worst time to buy stocks when valuations are high.

Instead of chasing previous performance, it’s important to preserve the integrity of your asset allocation. For example, if you've allocated a certain percentage of your portfolio to bonds or a certain percentage international stocks and those percentages have changed with the market, it makes sense to rebalance back to your desired allocation.

Examine your situation
Everyone’s financial plan is different, so it’s best to think about your individual goals for your portfolio. Is it there to provide current income? To cultivate a long-term nest egg? To provide funding for a specific purchase?

Once you’ve examined your goals, you should evaluate your liquidity needs. How much do you anticipate withdrawing in the next 12 months? Divide that into two camps: regular withdrawals and extraordinary expenses, such as paying for college tuition or purchasing a beach house. Then, make sure the money you need for the next year is budgeted for, either in cash or through dividends and interest coming that will to cover those expenses. You don’t want to be in a position where you need to sell stocks or bonds to pay your bills.

For example, say you have a $1 million portfolio and need to withdraw $30,000 over the next year. Factor in that withdrawal rate and how much income you have coming in from the portfolio in the form of interest in dividends. Once you know how much principle you need, you will have a better idea of how much risk you can take with your portfolio. If you only need a small percentage of the principle, you can afford to ride out a rough patch. However, if you need to fund a down payment on a house, you might want to remove those funds from the market.

No matter your situation, it’s important to talk to your financial advisor about your concerns instead of getting caught up in blanket buy-or-sell decisions. Your advisor can help you preserve your long-term plan while providing some liquidity to put your mind at ease and help you sleep at night.   

Simon Hamilton is managing director of The Wise Investor Group at Baird in Reston.