Investors have to be aware that volatility is a natural part of trading in stocks. In general, markets have a few good years followed by a less-than-stellar year or two. That’s precisely why investors need to adopt a long-term view, as well as the ability to withstand all of the swings in the markets.
Volatility is the relative rate at which the price of a security moves up and down. It can get pretty complicated, particularly when you burrow into the statistics, it can be found by calculating the annualized standard deviation of daily change in price. If the price of a stock moves up and down rapidly over short time periods, it has high volatility. If the price almost never changes, it has low volatility.
Of course, while everyone is happy with a booming market, any downward trend can generate panic. Plus, while a seasoned investor may have a higher tolerance for volatility, a new investor always has the fear of losing his or her initial investment and will be tempted to pull out of the market completely.
In rising stock markets, many investors often take on more risk than they're suited for. They only realize they've taken on too much risk when they experience the negative effects of that risk—when the market goes down. This was underscored in the late '90s, when large numbers of investors jumped into the market and didn't rebalance. They ended up with a larger percentage of stocks in their portfolios than their risk levels warranted.
Many even added to their already over weighted technology positions by buying more and more, assuming the upward trend would continue indefinitely, often with little thought as to the impact it might have on their portfolios. When the market began to slide sharply in 2000, their investments got hammered.
Spurred by panic, many scrambled to unload while others held on to their losing positions, desperately hoping their investments would rebound. For those who added to their stock positions during the upward market cycle, they ended up buying high and selling low—contrary to economic rationality.
For those who invest through a well-defined financial plan, however, the best way to handle volatility is to ignore it altogether. If you don’t need the money, you can wait for the markets to recover.
These important tips can help you to weather turbulent market cycles:
1) Diversify your portfolio.
This is an investment technique that uses many varied investments within a single portfolio. The idea behind it is that a portfolio of different kinds of investments may, on average, yield higher returns and pose a lower risk than a single investment. It tries to smooth out volatility in a portfolio caused by market, interest rate, currency and geopolitical risks. Bear in mind, however, that diversification does not assure against a loss.
2) Rebalance your investments.
Your investments will gain and lose value as the market rises and falls. Review your mix in real estate, mutual funds, individual stocks, bank products and annuities. Because some investments will grow faster than others, you may need to move money from one investment to another in order to maintain the same asset allocation percentages you originally chose. However, your decision to rebalance should be based on your long-term investment strategy, not market results on a certain day.
3) Keep a cool head and don’t panic.
Stay focused on your long-term goals. It’s important to remember markets go up and down, and if you made a financial plan, it would have taken this type of market volatility into account. The worst thing you can do as an investor is panic and sell everything and then wait for the market to recover. Remember, large market gains often come about in quick and unpredictable spurts, and missing just a few days of strong market returns can substantially erode long-term performance. So stay invested.
4) Look for opportunities.
The market decline actually gives you a chance to buy quality stocks at lower prices. Since history has shown that American markets have the ability to survive and prosper, then holding on and even buying more on the dips will prove to be successful.
5) Manage your risk.
Experienced traders make it a rule to enter a stop-loss order whenever they take a position. Throughout the years, they’ve learned not to invest or trade without a safety net. With a stop loss in place, the trader can be golfing, at work, or on a trip and if the stock drops and hits the stop price, the order converts to a sell order and the stock is immediately sold at whatever the current market price is.
But how does an investor determine where to place a stop loss? Traders will usually set their stop loss somewhat below a price where the stock is likely to get support. If the stock bounces every time it drops to $30, that means there is support at $30. If a stock is in a rising trend, and the trend line defining its rise is at $39, a trader might therefore set the stop-loss order at $38.
[Read on to learn more about How to Cancel Risk With Stop-Loss Orders.]
6) Consider your timeline.
Always consider how close you are to needing money before selling shares or making changes in your investment strategy. For someone in their mid-20s to late 40s, they should see the slide in the stock market as an opportunity to buy low. Historically, the stock market has always bounced back with time.