“Everyone has the brain power to make money in stocks. Not everyone has the stomach,” once observed legendary fund manager Peter Lynch. His point was that most people don’t have the stomach – or emotional stamina – for sticking to an investment plan when market conditions get choppy.
What makes 2018 remarkably different from the recent past is rising stock market volatility. Since the start of the year, the CBOE Volatility Index (^VIX) has shot higher by around 100% and at one point was up almost +250%. By comparison, this is the same crazy VIX index that was -42.5% for the three-year period from January 2015 to December 2017. How sharp has the reversal in stock market volatility from down to up been? During the first two months of 2018 alone, the VIX erased three-years of calm.
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While rising volatility might put certain people on edge, it’s not necessarily bad. After all, if a fearless stock market is a dangerous place to invest, then the opposite equally applies – a fearful market is a much safer place than it may seem at the time.
Let’s examine three strategies for managing market volatility.
The easiest way to avoid stock market volatility is to put 100% of your money in assets with minimal to zero volatility. One example of this might be putting your money into a bank savings account with a low yield but with decent liquidity and some level of principal protection.
Another example would be to keep your money stored in a private vault or hidden underneath the proverbial “mattress.” While both choices may limit market volatility, they aren’t without risk. Vaults can be breached and mattresses can burn to the ground if the house catches fire. Also, the threat of inflation – especially over long periods of time – erodes the buying power of un-invested money.
Although the short-term benefits for avoiding market volatility might seem like a good idea, there are serious long-term risks and side-effects.
Instead of boycotting the stock market altogether, some investors decide to participate, but to hedge the ups and downs.
Let’s suppose you own the Vanguard FTSE Developed Markets ETF (NYSEARCA:VEA), a popular fund with exposure to non-U.S. stocks in economically established countries. You could buy VEA put options to protect your long position in VEA. Any market decline that VEA might suffer would be offset by a corresponding gain the the VEA put options, thereby muting the financial impact of surging volatility.
Another hedging strategy – which is among our least favorite – is to invest in ETFs (NYSEARCA:SPLV) that own stocks with less volatility compared to the broader market. These so-called “low volatility” ETFs have attracted billions of dollars in AUM but hidden problems abound.
First, virtually all “low vol” ETFs were launched during calm market conditions from 2010 to 2017 and thus remain untested during periods of high and sustained market volatility.
Finally, the other issue facing “low vol” ETFs is a performance problem. “Outperforming the market with low volatility on a consistent basis is an impossibility. I outperformed the market for 30 odd years, but not with low volatility,” once quipped George Soros. His observations ring true and many of the largest ETFs by AUM that attempt to reduce market volatility have delivered substantial underperformance during the past three, five, and seven-year periods. It’s doubtful these funds will suddenly shine when market conditions become unfavorable.
The final approach is to embrace market volatility and make it your friend.
Here’s a recent example: On January 31, 2018 via ETFguide’s Weekly Picks we wrote:
“Although U.S. stocks are off to a hot start in 2018, so is stock market volatility. The CBOE S&P 500 VIX index is +33% since the beginning of the year and a new, unsettling dynamic of rising stock prices and volatility has unfolded. ‘Do the trade that makes you puke!’ was the sage advice of billionaire investor Paul Tudor Jones II. And we can honestly say that going long volatility makes us absolutely puke. Nevertheless, the short-term uptrend in volatility can’t be denied. We’re adding the ProShares VIX ST Futures ETF (NYSEARCA:VIXY) at current prices near $24.80 up to a buy limit of $25.”
As market volatility and the fear of falling stock prices soared, we subsequently sold VIXY for a tidy +69% gain at $42.23 on Feb. 6. This is a classic example of embracing volatility, rather than avoiding it. And while befriending volatility has been an out-of-favor approach during the past several years, our Jan. 31st trade alert was the right move at the right time based upon market condition readings.
Now that you have been given three strategies for dealing with market volatility, I’d like to offer one final bonus strategy: always invest with a “margin of safety.”
In the context of a portfolio of investments, “margin of safety” represents the portion of your investments that is invested in cash equivalents or other instruments with zero volatility, 100% liquidity, and principal protection. “The true investor welcomes volatility…a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses,” noted Warren Buffett. The sad irony is that far too many investors will never be able to capitalize on “irrationally low prices” because they lack an adequate “margin of safety.”
Remember: Investors with a margin of safety have the flexibility to capitalize on volatility and falling prices. They can buy wonderful assets on the cheap, while the rest of the world is selling. In contrast, fully invested portfolios are offered no such benefits because they are victimized by volatility and thereby forced to ride falling prices down to the basement.
In the end, managing higher volatility, executed properly, is a winning strategy!