If history is a guide, there will always be periods of market volatility, with dramatic swings both up and down. While not uncommon, these times can be anxiety-producing for investors. Your portfolio may be negatively affected, and you may question whether you need a different financial strategy.
Understanding market volatility and its potential causes may help you better manage the emotions and behaviors that come with it. Another key ingredient to handling market volatility is having a financial plan. A comprehensive plan is designed to reflect the financial goals you ultimately want to achieve and to help you stay on track in a turbulent market.
What is market volatility?
The stock markets sometimes experience sharp and unpredictable price movements, either down or up. These movements are often referred to as a “volatile market” and can occur over a period of days, weeks, or months. You should expect volatility from time-to-time, but it’s important to note that these tend to be temporary stages in the markets. In fact, a market decline can provide investors a good value in specific investments that experience a temporary drop.
While the term “volatility” applies to both up and down market movements, investors tend to be more concerned about volatility to the downside. A slide of 10% or more in a major market index (Dow Jones Industrial Average, S&P 500, NASDAQ Composite) is considered a “market correction.” A decline of 20% or more is considered a “bear market” (an increase of 20% or more after a bear market is known as a “bull market”).
What causes market volatility?
While market volatility can happen suddenly, with little warning, it rarely occurs for no reason. Causes of a volatile environment vary, but can include:
- Surprising economic news that differs from the expectations of investors (i.e., an unexpectedly high result for the Consumer Price Index measuring inflation).
- A sudden change in monetary policy, such as the Federal Reserve announcing plans to raise short-term interest rates.
- Political developments including unexpected election results, an event such as a government shutdown or passage of key legislation designed to give the economy a boost.
- Geopolitical events such as an outbreak of a military conflict or flaring tensions between powerful nations that could have economic ramifications. Recently, for example, the Dow Jones Industrial Average crossed into bear market territory shortly after Russia invaded Ukraine.
- Events specific to markets, such as stocks becoming overvalued. This occurred in 2000 when a number of overpriced “dot-com” stocks faced a sudden and dramatic selloff as investors became concerned that prices had outdistanced underlying company fundamentals.
5 steps you can take when the market is volatile
While it’s essential to maintain a proper perspective during these periods, there are steps you can take to help you better prepare for market volatility in the future.
You should expect volatility from time-to-time but remember that these tend to be temporary stages in the markets. In fact, a market decline can provide investors a good value in specific investments that experience a temporary drop.
1. Establish or revisit your financial plan
One of the benefits of having a plan in the first place is that it already has some security wrapped into it. As you create or review your plan, here are specific actions to consider:
- Take a closer look at your financial goals and your time horizon to reach those goals. If they’re no longer realistic, make adjustments so you can stay on track to meet your most important goals.
- Review your monthly budget to assure you’re comfortable with your income and expenditures. You want to be able to cover essential expenses at all times.
- If necessary, try to find ways to reduce spending by 3% or more so you can set additional dollars aside toward your most important financial goals.
2. Increase your emergency fund
Your emergency cash savings serve as a financial cushion through difficult times or if unexpected expenses occur. The conventional wisdom is that you should have the equivalent of three-to-six months’ worth of income readily available to tap for immediate needs if they arise.
If your income is subject to greater fluctuation in economically challenging periods or just by the nature of the work you do, consider bumping that up to six-to-nine months or longer. It will provide greater financial flexibility to help you get through challenging periods.
3. Re-assess your risk tolerance level
Your investment strategy is derived in large part from the level of risk you’re willing to take. From time-to-time, you’ll want to reexamine your views on investment risk.
Among the questions that can help you assess your risk tolerance level are:
- Are you willing to accept moderate losses in your investments over a period of time and demonstrate the patience needed to overcome those setbacks? If you are, you could position your investments assuming a high or moderately high risk tolerance level.
- Do you become uncomfortable and nervous about your portfolio during down markets? If so, you may want to reduce the amount of risk in your portfolio.
- What is your time horizon to retirement? If you’re nearing retirement age (within five years or less), you may want to scale back the amount of risk in your portfolio to avoid any significant losses that could occur just before or once you’re in retirement. By contrast, if you’re 20 years or more away from retirement, time is on your side. You may be in a better position to take on more risk in order to potentially earn a higher return and ride through the market’s challenging periods.
4. Make sure your portfolio is properly diversified
A portfolio that’s diversified to better weather market volatility begins with owning an appropriate mix of investments aligned with your risk tolerance level.
- The mix of assets you hold should spread among three broad investment categories – stocks, bonds and cash.
- Diversify further within each category through different investment types. With stocks, you may want to include small-, medium and large-cap stocks along with international stocks. You may want to include some combination of growth and value stocks, as well as specific industry sectors in your asset mix. With bonds you may want to consider government bonds, corporate bonds, and bonds of different maturities.
Reassess your portfolio at least annually to determine if any adjustments need to be made. As your asset allocations rise or fall in value due to varied investment performance, you may want to rebalance your portfolio to keep it in alignment with your primary objectives.
5. Talk with your financial professional
An experienced financial professional can review your current plan or guide you through the process of developing a plan to help you feel confident that you’re on track toward your financial goals.
Even if you’re currently comfortable with your plan and investment portfolio, the economic environment can quickly change. A financial professional can help assess your circumstances and adjust your plan as necessary to either protect your financial position or take advantage of new opportunities in the market.