When stock markets start sliding and fear becomes the overwhelming emotion driving investor sentiment, it’s almost impossible not to want to do something– anything. But should you? I’m anything but a long-term “buy-and-hold” strategist, so yes, there are times when you need to do something. But those times typically are notwhen the market is gyrating by hundreds of points a day. Here’s my take on the recent market roller coaster, and some practical guidance on dealing with market volatility.
Markets fluctuate for many reasons. Sometimes, the market needs to correct so that a new growth cycle can begin. This would be the normal ebb and flow of a market over time. In other cases, markets fluctuate because of compounding fears. These fears may come from the belief that the economy is not growing as fast as the stock market is, and thus the selling begins.
The selling continues when stop-loss orders are triggered or when quantitative or algorithmic formulas are triggered, inducing additional selling. Sometimes margin calls occur for those investors using borrowed funds. To put the current account back into an appropriate status, good stocks are often sold alongside the decliners.
This compounded selling often results in significant market losses over short periods of time, much like what we experienced during January. These periods typically are fueled by the fear that selling will last longer, resulting in even more capital loss.
So what is an investor to do during periods like this? Do you sell? Do you buy more? Do you hold? Do you start looking for a second job?
There are many opinions on this topic, because there are also many risks. If you don’t sell, and the market continues to decline, then you run the risk of seeing 10% to 30% or more of your portfolio decline. If you do sell, and the market quickly rebounds, then you’re now worse off than if you had done nothing at all. Either way, the emotions that go along with these decisions are considerable. In a way, you are damned if you do and damned if you don’t.
What to do
The following points are my opinion as a registered Portfolio Manager. I need to make these types of decisions on a daily basis on behalf of my clients, and so what follows are the things that I think about. This is also a very controversial subject where different people have very different – and strong – opinions. Therefore, it is likely that you will look at some of the points I mention below and think that they are a little crazy.
But before you judge, here’s the main point I wish to share with you: Every strategy has its strengths, weaknesses, faults, and benefits. But what is the right strategy for you, based on your unique circumstances, at this stage in your life? Do you have a strategy or are you simply responding to each change in the market?
Three questions to ask
1. What’s the downside risk?I ask this with every security I own, or that I consider owning. To measure this risk, I like to use many of the common tools of technical analysis. These help me determine what I believe is the downside risk, so that I can then do side-by-side comparisons between each of the securities I own.
It also helps me determine the downside risks of the overall market or of specific sectors of the economy. If the downside risk is considerable, then I may consider a sell strategy that trims a position over time, so that I protect profit and keep my asset mix appropriately balanced.
2.·How do the securities in my portfolio work together?Where are the risks in my portfolio? In general, it is my preference to equal weight similar securities with similar risk profiles in my client portfolios. If one security has done very well and is now out of balance with the other similar securities, then I may consider taking profit on this security and trimming back my position to a normal weight.
I would also typically monitor over time the “correlation” of different securities in my portfolio. For example, this past year we saw many days when half the market was rising while the other half was falling. On alternate days, we would then see the opposite. If I see that all of my securities are rising together, then I may wish to rebalance the portfolio so that I had a better diversification between difference securities.
Over time this would typically produce a portfolio with lower volatility and a reasonable, modest return. This approach helps me determine the overall risk profile of the portfolio, which then helps me determine if I should be concerned about the short-term volatility of the market.
3. What if I am wrong?Before I process a sell order, I consider this all-too-important question. What if I sell, and the market rebounds? What if I sell only half, and the market continues to decline? What would be the impact on the portfolio returns? If I am comfortable with these various outcomes, then I feel confident that the sell order is a reasonable approach to take.
In most cases, in my experience, the best approach is to enter new positions gradually and exit current positions gradually. This helps to reduce the negative impact “if you are wrong.”
I could add further detail to these and other points, but the bottom line is that it is extremely important that you have a disciplined buy and sell strategy. Selling when fear dominates the market is typically not a good strategy. Instead, before fear hits the market, you should already be measuring the downside risk of your various investments, the downside risk of your overall portfolio, and have thought through the pros and cons if your decision is wrong.
Remember, in most cases, you are damned if you do and damned if you don’t. In other words, no matter what you do, you are likely to be wrong in some way. But this is not a question of being right or being wrong – it is a question of managing risk and building wealth consistently over time.
Market ebbs and flows, so does your portfolio
I personally do not believe in buying and holding either individual stocks, or the overall market index, over time. I believe that every stock, and the market as a whole, ebbs and flows and that it is okay to manage your portfolio over time by buying when the risks are low and selling or trimming positions when the risks are high.
To my mind, this is just the prudent thing to do. But investors have a greater opportunity for mistakes if they do not have a disciplined strategy to deal with typical volatility and risks over time. As I said previously, the worst time to try to manage these risks is when the fear in the market is high. Instead, the goal is to manage these risks over time so that when volatile markets do arise, as they inevitably do, your portfolio is ready to handle them effectively and efficiently.
In my portfolios over the past few weeks, we made an asset allocation adjustment of approximately 5%. We have reduced our equity holdings and increased our cash by only this amount because the other components in the portfolio met our risk analysis parameters well. In other words, we made some small changes, but nothing significant. Instead, over the past year we were gradually making changes each month. By the time the larger selling began in January, we were already more conservative than we had been at any time in the previous 12 months.
Simply put, the road to portfolio happiness is to 1) have a clearly defined buy and sell discipline that 2) you evaluate and review on a regular basis. This will help you manage your portfolio risks over time. And this will ensure you are ready when markets fluctuate.
Courtesy Fundata Canada Inc. © 2016. Doug Nelson, B.Comm., CFP, CLU, CIM, is President of Winnipeg-based Nelson Financial Consultants. This article is not intended as personalized advice.
