Seven strategies to help manage volatility and risk
For some investors, a market downswing is like a surprise encounter with a hungry lion: it triggers an instinctive fight or flight response. In fact, behavioral finance suggests that in moments of distress—such as during market turmoil—emotions dominate the decision-making process. This can lead even experienced investors, who should have a long-term outlook, to only focus on the perceived risks associated with short-term market turbulence. In behavioural economics, that condition is called “myopic loss aversion.” The result? Anxiety or even, in more extreme cases, panic selling.
If you’re invested in stocks, you know about volatility—it’s the nature of markets to rise and fall. But it’s important to separate volatility from risk. Volatility simply describes the degree of price variation over a given period of time. Risk, on the other hand, can mean a few different things, depending on the context. It refers to the possibility of losing some or all of your money permanently. It can also refer to the risk of falling short of your investing goals, or underperforming inflation.
The good news about volatility and risk is that both can be managed. Here are several strategies you can implement to mitigate volatility and reduce risk.
Diversify your portfolio
A well-diversified portfolio containing a broad mix of equities, bonds and cash will likely be less volatile over the long term than a portfolio concentrated in only a few investments. In a well-diversified portfolio, losses in one area tend to be offset with gains in other areas. For example, bonds and stocks often move in opposite directions. On the other hand, in a concentrated equity-only portfolio, both losses and gains can have a bigger impact. So if you want to mitigate the level of volatility in your portfolio, diversification is one of the keys.
Dollar-cost average into the market
Another approach that can help ease concern over volatility is dollar-cost averaging (DCA). This strategy involves investing a pre-determined amount on a set schedule—say, every month or every quarter—regardless of market conditions. No need to worry about whether prices are heading up or down, because this mechanical process eliminates emotion. You’ll naturally buy more when prices are lower, and less when prices are higher.
To learn more about DCA, read our article Concerned about volatility? Dollar-cost averaging may mitigate risk and enhance returns
Balance risk and reward
The way you allocate assets across stocks, bonds, cash and other asset categories lays the foundation for your investment outcome. For many investors, asset allocation precedes the selection of individual securities. More than anything, it’s your asset allocation that determines the risk/reward profile of your portfolio, and you can calibrate that profile by setting target proportions of different asset classes. How do you determine your asset allocation model? You need to consider your goals, timeline, comfort level with volatility, and your tolerance for risk. As always, keep in mind that the lower the risk, the lower the expected return.
For example, a portfolio allocated entirely to speculative, growth-oriented stocks would be considered extremely aggressive. It would have the potential for big gains, but also the potential for big losses. And from a cold, analytical point of view, the potential for gains may not justify the level of risk.
A portfolio allocated entirely to GICs or federal government bonds would be considered extremely conservative: low risk and low return. But if returns are so low that they don’t even keep pace with inflation, then the purchasing power of your savings will steadily decline.
Most long-term investors choose a more balanced asset allocation model: a large proportion for equities, which may be sub-divided into portions for domestic, U.S. and foreign stocks across a variety of sectors; a large proportion for fixed-income; a smaller allocation for cash; and perhaps additional small allocations to speciality categories or themes such as real estate or precious metals.
Don’t follow the herd
One way to potentially reduce portfolio risk is to avoid following herd mentality. When you have a portfolio based on a long-term outlook, there’s less of a need to respond to short-term events. According to behavioural finance, herd behaviour may be a psychological trap. For example, based on negative economic news, some investors decide to sell. Others are spooked by that trend and follow suit, and suddenly there is a major correction as a big crowd of investors dump their shares. Rather than follow the herd, investors are often better off staying the course, and simply waiting for prices to recover. It can be hard to sit tight when pessimism prevails, but such a rational response could spare you the pain of locking in a permanent loss. Similarly, in periods of market euphoria, following the herd can lead people into adding overhyped and subsequently overpriced investments.
Don’t try to time the market
Markets are inherently unpredictable, and it’s impossible to correctly guess with any regularity, the best time to buy or sell. The old adage applies: “it’s time in the market, not market timing, that builds wealth.”
Take advantage of market volatility
The natural ebbs and flows of market prices, and the crowd’s fear or greed, can generate opportunities if you take a rational, disciplined approach.
By taking time to understand a company’s fundamental health, you can set a target price for its shares. Then, if a pessimistic market mood drives the price below the target, you have an opportunity to buy that stock while it’s effectively on sale. If a euphoric market mood drives the price well above your target, you have an opportunity to sell and take some profits. The key to success with this approach is that it’s based on a rational, pre-set plan.
Market volatility also generates opportunities for technical traders who watch market data for patterns that might indicate buy or sell signals. This is a more sophisticated approach for well-educated, experienced investors. Again, the discipline to avoid emotions and make rational decisions is the key to success for technical traders.
Keep your emotions in check
It’s important to remember that market volatility is the natural result of the relentless tug-of-war between bulls and bears and that investing entails assuming some degree of risk. So focus on your goals and don’t let short-term volatility derail your long-term investment plans. Consider tweaking your holdings, but think twice before making major shifts. Keep your emotions in check and remember that overcoming behavioral biases at both the peaks and valleys of the market is pivotal in making wise investment decisions. Remind yourself that there’s no reason to dump stocks with good fundamentals just because other investors have decided to exit the market. After all, there’s no wild predator chasing you.
For more on volatility, read our article Volatility matters: Why you should watch the VIX.
Resources:
Rediff, Nathan. “Behavioral Finance: Anomalies.” Investopedia. https://www.investopedia.com/university/behavioral_finance/behavioral3.asp