While the stock market can be a powerful wealth generator over long periods, it’s not without its downsides as well. In fact, certain periods can be so volatile, with such aggressive downswings, that investors can lose their resolve and find themselves panic selling at the worst possible times.
Preparing for the ups and downs of a volatile market is key to avoiding panic selling as well as chasing overpriced markets. When I think about prepping for volatile markets, I compare it to preparing for a hurricane.
Having lived in Florida for over 40 years, my fellow Floridians and I have prepared for quite a few hurricanes over those years. We know that a Category 1 or 2 hurricane will likely result in a few palm tree limbs in the street, a few toppled mailboxes and maybe even a broken window or two. Some relatively minor damage, but nothing too serious, so we prepare accordingly. We also know that once a hurricane reaches Category 3 or 4, we have to up our game with preparedness. The arrangements made in these cases shift because these storms could be a lot more hazardous. Lastly, the most destructive and powerful storm is the Category 5 hurricane. These storms require serious preparatory measures because we really have to buckle down while some residents simply say “we’re heading for the hills” and leave town. The only good thing about Cat 5 storms is that they happen the least frequently.
Preparing your finances is very similar. Just as Cat 1 or 2 storms are most common, the markets regularly experience short-term pullbacks. Although a downswing of 5-10% can be somewhat unsettling, the damage is usually limited (not related to a recession) and therefore it doesn’t take too long before things are back on track. This is where the idea of “buy the dip” comes from, using a short-term market pullback as a way to buy into the market. Other times, like Cat 3 or 4 storms, the market may experience a slightly more aggressive sell-off, with downswings as high as 10% to 30%. These happen less frequently and because they are relatively more serious, take a little longer to recover from. Usually these types of drops occur either in anticipation of a possible recession or the experience of an actual, brief recession. And then there are the rare few times, the Category 5 versions, like the year 2000 dot com bubble or the financial crisis of ‘08, where we will see a much more significant sell-off and a prolonged recession. While this doesn’t happen often, just like a Cat 5 hurricane, it is essential to recognize it’s a possibility and make preparations accordingly.
So, how can you prepare for market volatility?
- Prepare before for the next big market drop.
One of the most critical steps you can take to prepare for market volatility is to re-assess your risk tolerance and rebalance your investment portfolio BEFORE it happens. The time to update your risk tolerance is not during the storm but rather before the storm hits. That’s because if you wait until it is volatile to make these changes, the fear you may be experiencing at that time can significantly alter your decision-making abilities, potentially causing you to overcorrect and make adjustments based on emotions. In addition, if you wait until a significant drop to take stock exposure off the table, you end up selling and locking in losses at much lower prices.
- Know that your risk tolerance will likely change over time.
An interesting phenomenon that I have seen over the years is that when investors are starting out accumulating their portfolio, and their account balances are relatively small, big swings in the market aren’t as scary. Even though they experience the same percentage drop in the market as everyone else, investors just starting out are typically less phased because they aren’t experiencing as much of a decline in total dollar amounts. A 25% drop on a $10,000 account, is $2,500. While I’m not suggesting $2,500 is insignificant, I’m simply stating that based on my experience, most people would not look at the $2,500 and feel that they have to make dramatic lifestyle adjustments. I also think that psychologically, the human mind assumes the mathematical recovery of the $2,500 as very plausible, through a rising market.
That said, I find that investors who have amassed larger sums of money or those who have suddenly come into larger amounts of money, are more sensitive to drops in their portfolio because a 25% drop on a very large sum of money “feels” different than a 25% on a smaller sum of money. In this case, the human mind, in an emotional state, sees the mathematical recovery of the larger dollar sum as very difficult or maybe even impossible, because it’s so large. For this reason, I find that for many investors, their appetite for risk decreases faster than they might have initially anticipated, which should be reflected accordingly in their investment portfolio.
For many, this may mean taking risk off the table by reducing the parts of their portfolio that are exposed to more volatile asset categories while increasing their allocation to more predictable and stable investment vehicles.
- Understand your plan.
Lastly, it is essential to understand your plan to prepare for volatile markets. According to FactSet, as measured by the Dow Jones, from 1901 through 2020 about 74% of the 120 years finished in the green and were positive years. That’s a great track record. You have to consider though, the other 26% of the years finished in the red and were negative. If you are working with a financial planner, you should know what your financial planner is doing to manage your risk and understand why.
Having a solid financial plan in place can help you feel at peace, despite the ups and downs in the markets. For example, suppose you understand your financial plan and know that even if the market takes a significant dip, you will still be on track to retire in the next decade, with enough money to travel around the country and visit your grandchildren. In that case, the volatility becomes easier to handle.
In addition, if you know that your financial advisor rebalances your portfolio during market downturns, helping you maintain the correct ratio of stocks to bonds, all while acquiring more stocks at a relative discount, you may find that downswings can be less scary and present more of an opportunity.
I am here to help.
As a CERTIFIED FINANCIAL PLANNER™ professional with over three and a half decades of experience, I have not only seen incredible market volatility but have also helped my clients navigate through those tough times. Helping clients prepare for market volatility and avoid making emotional decisions during those times is an integral part of my work to help clients experience financial success, despite volatility.
If you’re interested in a complimentary call to discuss your financial plan and prepare for market volatility, you can schedule time directly on my calendar, free of charge.