While we have enjoyed a bull run in equity markets for the last 5 years, investors are becoming increasingly concerned that we could be entering a bear market. This refers to a period of decreasing equity prices.
At the very least, we can definitely say that volatility is back.
Investopedia defines volatility as:
“a statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security.”
Volatility can be used to talk about a specific stock or it can be used more generally to define the market. Said more simply, volatility is an indicator of how susceptible something is to change in a rapid and unpredictable fashion.
When it comes to stocks and other investments, volatility is not something we are generally looking for. The exception to this rule would be regular traders who take advantage of the short ups and downs of the market to capture profits.
But for the average investor, looking for a solid return on their savings, volatility can cause pain and anxiety. Humans are risk-averse by nature, and volatility is something we are hard-wired to avoid.
Imagine waking up one morning, only to find that 5-10% of your savings have just vanished.
First of all, don’t panic! Keep calm and do some reading. The worst thing you can do is sell at a low.
In most cases, I would simply advise to hold on to whatever you have, be it a stock or even real estate. But how you deal with market slumps or volatility will depend on what type of investor you are.
There are a few very important things we must consider when the market begins to swing.
Determine Your Financial Objectives.
If you haven’t already, get to it. If you have, make sure you re-evaluate these objectives in a crisis situation.
Your financial objectives are what gives purpose to your investment. What is your goal? Why are you working so hard to save and invest?
Here are a few examples of typical financial objectives:
- Save enough in after-tax investments to give yourself optionality to do something new.
- Return at least 2X the risk-free rate of return each year.
- Save enough to pay for your kid’s education.
- Save enough to cover any long-term care costs for aging parents.
Your financial objective will define your investment strategy. You may make a different decision depending on how close you are to it. This will also affect a very important factor which we will talk about in the next section; risk tolerance
How Risk-Averse are you?
Like I said previously, being averse to risk is something natural in human behavior. That’s why risk is rewarded. Normally, younger people, especially men, are more tolerant to risk. The older we get, the more averse to risk we become.
Determining your risk tolerance is easy to do, just ask yourself what you would do if the stock market fell by 10%. Would you cash out or hold your stocks?
If you never plan to sell because you know stocks and bonds have generally gone up and to the right for decades, perhaps you have a high risk tolerance. If you plan to take profits if the stock market is down 20% or more, perhaps you have a medium risk tolerance. If you’re freaked out by a 10% correction, then perhaps your risk tolerance is very low.
Your risk tolerance will determine not only how you react to a volatile market, but also how you prepare for it.
For the most part, government bonds are considered “risk-free” assets. Investors tend to combine these bonds with other more risky assets such as equities or real-estate.
Here’s a list of the returns one could expect using different weightings of bonds and equities in the last 80 years.
- A 0% weighting in stocks and a 100% weighting in bonds has provided an average annual return of 5.4% since 1926, beating inflation by roughly 3% a year.
- A 20% weighting in stocks and an 80% weighting in bonds has provided an average annual return of 6.6%, with the worst year -10.1% and the best year 29.8%.
- A 40% weighting in stocks and a 60% weighting in bonds has provided an average annual return of 7.8%, with the worst year -18.4% and the best year +27.9%.
- A 60% weighting in stocks and a 40% weighting in bonds has provided an average annual .
- An 80% weighting in stocks and a 20% weighting in bonds has provided an average annual return of 9.5%, with the worst year -34.9% and the best year +45.4%.
- A 100% weighting in stocks and a 0% weighting in bonds has provided an average annual return of 10.2%, with the worst year -40.1% and best year +54.2%. We saw this sell-off happen in 2008-2009 when many investors sold at the absolute bottom.
Another good rule of thumb to follow is this: The higher your savings are the less risk you should be taking since you have that much more to lose.
The first few years you begin saving and investing, achieving a 10% return will help you loads. But let’s say you have, hypothetically, managed to accumulate 1 million pounds. Achieving an almost risk-free return of 3% on this would make you an extra 30.000 pounds in a year. How much do you value an extra, say 50.000 pounds when you are putting your savings on the line?
I guess what I’m trying to say is that money, like most goods, has a decreasing return. Meaning the first million you make is worth so much more than the second one. Going from zero to one million means going from wondering how you will pay rent to being financially independent. But that second million is just going to make you slightly more comfortable.
In this situation, you really do have more to lose than to gain.
Read: Value Investing Guide
Make up for Your Losses
Another important piece of advice I will give you is this. If you have recently suffered from a dip in the market, get back on track by tackling the problem head on. Your financial objectives shouldn’t have changed, but you are further away from them, so make up the difference. Tackle the problem head on and pick up an extra source of income. Do an extra shift at work or pick up some freelancing work.
The alternative is to make up for your losses the other way, by reducing your expenses, something we discussed already here.
Lastly, make sure you keep enough cash so that you don’t feel like you have to pull some money out of stocks.
By having a cash hoard, you will not only have a financial cushion, you will also have the firepower to take action during violent sell-offs.
Buying stocks during a downturn is a positive that counteracts the negative of losing money from your investments.