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How to Handle Market Volatility

In Asset Allocation, Company News, Investments, Market Review, Personal Finance by Nick Faulkner

In recent days the increase in stock market volatility has resulted in renewed anxiety for many investors. Since October 1st, U.S. stocks (as measured by the S&P 500 Index) have declined by nearly 13% and are down more than 3% year to date.  International stocks have fared even worse declining by a bit more than 14% this year so far.

Due to these recent stock declines, many investors are wondering what the future holds and if they should make changes to their portfolios. While it may be difficult to remain calm during a stock market decline, it is important to keep things in perspective and remember that volatility is a normal part of investing.

In fact, we would argue that the possibility of stock declines is one of the primary reasons why investors demand and receive higher returns from stocks than other investments.

The following graph is a good reminder that on a long term basis investors are rewarded by accepting stock market risk. 

You will note that many “major market crises” are noted in the graph above.  It’s true that at the time, each of these events seemed very serious and downright scary.  The headlines fueled fear and prompted people to take action – abandoning a long term investment strategy at exactly the wrong moment.

Reacting in Response To Fear Can Adversely Impact Performance

Studies have consistently shown that timing the market is an impossible way to enhance portfolio performance.  This is because investors must be correct twice – exiting stocks at a high point (when good news dominates the headlines) and reinvesting after stocks have experienced a precipitous decline (when bad news dominates the headlines). 

It is best to maintain a tried and true approach to investing. One that is grounded in financial planning that helps put the odds in an investor’s favor. 

History has shown that those investors who remain calm and stay the course, even during periods of market turbulence, will reap the long-term benefits.  You will note in the graph below that those investors who missed out on only a few of the best trading days (of the nearly 6,800 trading days) during the 1997-2017 period would have seen their returns significantly impacted.

Understanding Your Emotions

It is completely understandable to experience nervousness or fear when watching stocks decline within a short period of time, or experience significant events that could negatively impact the stock market.

However, it is important to understand the role emotions can play in investing and avoid common investing mistakes. 

As shown above, people experience a predictable pattern of emotions that can coincide with the stock market.  That is, investors tend to be optimistic as stocks rise.  This optimism can lead to elation as investment gains continue.  Eventually, as the normal investment cycle progresses and economic growth slows or stalls, elation can turn to nervousness and eventually fear.  

It is during the extremes (elation and fear) in which investment mistakes are most commonly made. Investors tend to make speculative bets when experiencing elation (i.e.the technology bubble) and selling out of stocks as a result of their extreme fear.

How Do Successful Investors Manage Their Emotions?

Successful investors understand the fact that the financial markets fluctuate overtime.  However, they also recognize the following:

  • Good news is never really that good and bad news is never really that bad.  Maintaining an even keel when it comes to investing is essential.
  • Their portfolio is not “the market.”  That is, their portfolio is not comprised only of stocks (like the Dow Jones or S&P 500 Index).  Instead their portfolio is globally diversified and consists of both stocks and bonds.
  • Their investment strategy is customized to meet their needs and grounded in financial planning.  

While market volatility can be nerve-racking for investors, reacting emotionally and abandoning a long-term investment strategy is normally more harmful than helpful. Instead, successful investors recognize that market volatility is a normal component of investing for the long term and keep their emotions in check.