Is volatility your friend or foe? As we prepare for another year of volatile stock markets, this question is fundamental to how you will approach larger and more frequent price swings. Short-term traders call volatility their friend. But even day traders who love high volatility have days when they wished they had been invested in a safe money market fund. Most traders experience more losses than gains on sudden market moves, despite the most sophisticated hedging strategies.
Only a precious few active traders actually beat the market. So with all the studies and data stacked up against the odds of active trading beating the market, why put yourself through the nail-biting, hair-raising trading sessions? If you are a passive investor, you can still befriend volatility and use it to your advantage. Even a conservative investor sitting it out on the sidelines can benefit from an investment strategy for higher market volatility.
The VIX index, which tracks market volatility on the S&P 500, is not going out of 2015 quietly. If you feel you have been on a rough boat ride ever since the August spike, as the VIX chart below shows, prices continue to be choppy. Is higher volatility the new normal? Nobody knows for sure as we go into 2016, so it is best to be prepared.
Get Ready for a Rollercoaster Ride
If a more volatile 2016 is ahead, you do not want to be dallying in the short-term market. 2016 could be another wild ride. Over the long term, a conservative investment strategy is the best way to grow the value of your investment portfolio. Investors with high discipline will do best. Here are some tips on how to hunker down for an unpredictable 2016. The best advice is to avoid active investing.
If you think you can time the market, especially a very volatile one, then you have a talent that most investors do not. The best way to build up wealth is through a disciplined investment plan. Plan to invest a set amount each month, or paycheck.
Commonly known as dollar cost averaging, making fixed payments on a regular schedule will protect you against market gyrations. You may already have such a disciplined investment plan in place through regular salary or bank deductions to a 401K plan, or other retirement savings vehicle.
If, on the other hand, you make one lump sum payment at the beginning of the year, you will be subject to more concentrated market risk and larger losses. The trick is to spread the market risk out over the year by staggering your purchases. Here is how dollar cost averaging works. In the following example, the purchases of ABC stock are spread out over the first quarter of the year.
Dollar Cost Averaging
Amount Price No. of Shares
January $10,000 $100 100
February $10,000 $ 90 111.11
March $10,000 $ 80 125
Total Shares Purchased 336.11 Market Value $26,888.80 Instead, let’s say you invested a lump sum of $30,000 in ABC stock at the price of $100 per share on January 1. On April 1, the stock market falls 20%, and it is no April Fool’s joke. Your investment has fallen to $24,000 in three months. Ouch!
Alternatively, you could spread out your stock purchases over the three months, as shown in the Dollar Cost Averaging table above. As the stock price fell, you were able to pick up more stock at a lower price for a total of 336.11 shares by the end of the quarter. The value of these shares is $26,888.80.
By staggering your purchases over three months, you have cut your losses almost in half to 10.4%. When the price rises, you will buy fewer shares but the value of your existing investment will also rise. Over time, dollar cost average will deliver a higher return.
Balancing Asset Allocation By regularly balancing your asset allocation as part of your dollar cost averaging strategy, you can further offset downside risk while increasing returns. Your mix of equities and bonds will be determined by your age and risk profile. Younger investors may also have a higher percentage of alternative investments while older investors prefer to have more cash or liquid securities on hand. Decide on your optimal mix of stocks and bonds.
Let’s say you are 60% stocks and 40% bonds. If bracing for another wild year in 2016, even growth investors should consider a higher weighting in bonds. Fixed income investments act as a cushion. Bonds tend to move in the opposite direction of stocks, helping to mitigate any lost value in the event of a stock pullback, or worse, a bear market.
When making your monthly contribution, balance out your asset allocation based on market performance. If bonds are performing better than equity, invest a higher amount in stocks to maintain your 60/40 split. Portfolio rebalancing can lower the risk of losses.
Do Not Sweat It! With a prudent dollar cost averaging strategy, you are not going to experience the wild swings in gains and losses of the day trader, so why put yourself through the same level of stress? The money in your investment portfolio should not be money you will need in the next few years.
Instead of watching the market go up and down, research undervalued stocks. If the market does turn down, you will be ready to scoop up some solid companies at a discount. Hold on and enjoy the ride!
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