Market volatility can be unsettling, for even the savviest of investors. This article originally published by Scotiabank provides you with some investing tips on how to manage – and potentially benefit from – market volatility.
The notion of investing in the stock market without volatility is as illusory as a car without an engine. Like it or not, the two concepts invariably go hand-in-hand. But does that mean you should avoid volatility – and investing – altogether? Market uncertainty can naturally cause panic and lead to poor investment decisions yet by recognizing short-term market uncertainty for what it is, you can help ensure that it doesn’t derail your long-term goals. Here are five tried and tested principles that can help you gain needed perspective.
“Investing is most intelligent when it is most businesslike”
– Benjamin Graham
Keep Calm During Down Market and Carry On
Investors generally feel a financial loss about two and a half times more than a gain of the same magnitude*. Understandably, many of us experience a roller coaster of emotions when investing (as the diagram below illustrates), which can translate into poor buy and sell decisions. Being aware of these emotions during periods of increased volatility can help you avoid reaching for the antacids and keep you on the straight and narrow to reaching your goals.
Its Time, Not Timing
Why shouldn’t you automatically sell your investments when market uncertainty sets in? Because trying to time the ups and downs of the market is a bit like rolling the dice.
As the illustration below demonstrates, over a 10-year period if you’re out of the market for even a small number of days when the market is outperforming, you can substantially reduce your return potential. Staying invested – while not always easy – can potentially translate into a better outcome.
Manage Risk, Don’t Avoid It
Risk can be a loaded term when it comes to investing and is often misunderstood. Often seen as synonymous with risk, volatility simply measures how much the return of an investment or the broader market fluctuates, both up and down. While some may fixate on these fluctuations, the permanent loss of capital should be of greater concern. Reducing exposure to securities that are perceived as ‘risky’ will certainly lower market risk, but by doing so, long-term investors can be unduly exposed to inflation and longevity risk (the risk that you’ll outlive your savings).
Whether we like it or not, investing in the stock market and risk are a package deal. The key to long-term success is to manage your exposure to risk by using time and diversification to your advantage.
Diversification’s impact on three-year returns
While the performance of any portfolio can swing significantly each year, a balanced portfolio has historically resulted in fewer negative returns when compared to an all-stock portfolio over the long term.
Put Diversification to Work
Diversification often equated to not putting all your eggs in one basket, is a tried and tested technique that mixes different types of investments in a portfolio to lower risk.
By including investments that are less correlated to one another – or react differently to economic and market events – gains in some can help offset losses in others. As the chart below illustrates, a diversified portfolio of different asset classes provides the opportunity to participate in potential gains of each year’s top winner while aiming to lessen the negative impact of those at the bottom.
Take Advantage of Dollar-Cost Averaging
Dollar-cost averaging is an investment method used to help reduce the risk of timing a lump-sum investment. By investing a fixed dollar amount on a regular basis, the “dollar-cost averaging” process helps control the effect of market volatility by smoothing out the average cost per unit of mutual funds purchased. Over time, and in certain market conditions, it could result in a lower average cost and a higher return. The accompanying chart simulates a dollar-cost averaging strategy with a lump sum purchase from September of 2007 to September of 2009, a period punctuated by extreme market volatility and a significant correction.
While it’s important to note that dollar-cost averaging doesn’t always produce a better result than a lump sum purchase, its systematic approach makes investing easy and takes the guesswork out of deciding when to invest.