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The stock market has been a little bit of a roller coaster lately. After a record 2020, despite the pandemic, many of us entered 2021 with a euphoric feeling of riding the market high. Because if 2020 showed us that the stock market can reach crazy highs in the midst of a pandemic, then it must mean that it can also weather ANY storm that comes its way.
2020 was a record year for the number of retail investors. According to the NASDAQ, retail investors now account for 1/5th of all of the U.S. stock market’s trading volume and this continues to rise.
But alas, 2021 has had a bit of a rocky start, especially for market darling growth stocks, like Tesla.
For new investors, that’s when the panic sets in. The stock market and economy, in general, are cyclical. What goes up, must come down. These movements are not unexpected, nor are they new. As new information or new players enter the market, the stock market moves in either direction.
We can refer to historical events. But even recently, there have been events that have shaken the stock market. This often scares off investors. But soon enough, they reenter, and money flows back into the market.
Market volatility is an accepted side effect of being in the stock market. And we bear it because the stock market has consisently been one of the best investments for our generation.
Generally, the alternative to stocks is investing in bonds –but most investment-grade corporate bonds offer yields of just 1.5%.
What else can you do? Leave your money in the bank, but you would be losing about 2% annually thanks to inflation. And potentially even more, if the recently stoked fears of inflation are to be believed.
The stock market has been a source of wealth, on average, beating inflation. The average annual return of the S&P 500, from 1957 through 2018 is roughly 8%.
So we have no choice, but to invest in the stock market and weather the ups and downs of the stock market, also known as market volatility.
What is market volatility (really)
Volatility is a statistical measure, that helps gauge how risky security (or stock) is, based on movements in price as compared to its average price. It can be helpful in revealing how predictable the short-term value of the stock might be.
So when a stock trades at higher highs and lower lows, it is considered to be more volatile. When it trades around a more stable price, is it less volatile.
This metric can be measured for the entire stock market. And in fact, the VIX, or the Volatility Index aims to measure this number, by looking at how option futures are being traded. You can read up more on the VIX here. In March 2020, the VIX reached 66, as compared to 12.56 on the first trading day of the year in 2020. Generally, VIX values greater than 30 are generally linked to large volatility and VIX values below 20 generally correspond to stable, stress-free periods in the markets.
Why does Volatility matter?
If you are a risk-seeking individual, you will love volatility. Volatility creates opportunities because there is a greater range of prices that stocks are trading at, so there is a greater chance of being able to buy low, and sell high – if you time it right (of course) – and score a great deal.
The downside? It also increases the chances that you buy the stock at a higher price, and it drops much lower.
On the other hand, if you are risk-averse, and view the stock market as a place to park your money long-term, you probably don’t want to see large fluctuations in pricing. You would rather see small (hopefully positive) changes in your portfolio.
The average investor cannot influence volatility in the broader market. But we can make choices in our portfolio to make sure that we are not adversely affected by volatility.
Managing Volatility in your own portfolio
If you’re a long term investor – of course you want a good upside but be protected against the downside.
Here are a few strategies and tools that can help create a less volatile portfolio, so you can soundly sleep at night!
Diversify your holdings
Diversification is arguably the best strategy for managing volatility.
Diversification is an investment strategy of holding a variety of investments in your portfolio so that you are not overly exposed to stock-specific movements of only one stock.
Investment professionals have different recommendations and guidelines, to determine if your portfolio is adequately diversified. Some studies suggest 20-30, while others recommend a number closer to 50 companies.
The general idea is, however, to invest in a variety of types of things that don’t rise and fall at the same type, for the same reasons.
Here are some suggestions to consider in diversifying your portfolio:
- hold other types of investments (like real estate or bonds) along with stocks (like a traditional 60/40 portfolio)
- hold stocks in a variety of industries (so that they don’t move together)
- invest in index funds or ETFs (so you can hold multiple companies without purchasing each separately)
Evaluate your concentration
If you look at your current holdings and find that you have too much of one stock, one industry, it could be time to add more or diversify your holdings.
Rebalance if needed
Sometimes, when growth stocks increase in value more than the average stock market, it can throw off your diversification strategy. In that case, you may want to consider selling a portion or adding more funds into the portfolio to continue to be diversified.
Once you set up a diversification strategy, it is important to re-evaluate the strategy as well as your positions periodically.
Find comfort in History
Lately, the stock market has seen more volatility. In 2019, the average closing price of the VIX was 15.39 and in 2020 it was 27.98.
Don’t let volatility scare you in and out of the market. The stock market value though has also been on a general uptrend. In 2020, the S&P finished with a gain of 16.26%.
If volatility scares you, look at this set of data going back to 1930 – if an investor missed the S&P 500′s 10 best days each decade, the total return would stand at 28%. If, on the other hand, the investor held steady through the ups and downs, the return would have been 17,715%.
The lesson here? Don’t try to time the market, and don’t let it scare you into leaving. If you can afford to, stay and ride the market volatility!
Invest consistently
The average person is unable to time the market. And in fact, there are studies that show that professionals are not able to time the market either! According to Morningstar, actively managed portfolios that moved in and out of the market between 2004 and 2014 returned 1.5% less than passively managed portfolios.
So rather than trying to time the market, the best way to get the best price is to invest consistently. Whether that is monthly, bi-weekly, quarterly, whatever works for your investment strategy. This has been made easy for average investors, using Robo-advisors such as Wealthsimple Invest and Questrade Portfolios in Canada.
Are you a trader or investor?
This is a vital question to ask yourself when purchasing any stock. Because it can determine how long you plan to hold the stock. If you are a long-term investor, daily movements in the stock market should not be of concern to your investment strategy.
Most people should be long-term investors and not traders. Here’s the distinction, if you are interested.
Limit your exposure to trendy/”fun” assets
Cryptocurrency and Meme stocks have taken center stage. If you were able to time these trades at the right moments you of course would benefit from their volatility and significant upside. But with any significant upside, there is a significant downside.
If you do plan on investing in these meme stocks, understand your risk exposure. There is nothing wrong with allocating a small part of your portfolio as the “fun portfolio”. The question to ask yourself is, can you afford to lose it?
If you are an active investor, make sure to put limits in place, either on your trading platform or by creating a trading plan to make sure you exit each trade when it is appropriate for you.
Final Thoughts on Market Volatility
Unfortunately, market volatility is part and parcel of being invested in the stock market. There is an inherent risk, but if precautions are taken, the volatility will reward you for your time in the market, by helping you grow your wealth and reach your financial goals.