Let’s face it, whatever your political views, one thing that is clear about the Trump administration is that it is different from anything that has come before. That is especially true in terms of financial markets. Ever since tax cuts and deregulation were priced into stocks we have entered a period where the only discernible trend has been towards volatility, as stocks react to statements and tweets on economic and trade policy from the White House and Congress that are seemingly ever-changing and often contradictory.
Nor is the data helping. It feels like there are signs of strong growth (good!) and looming inflation (bad!) one month and then the opposite the next. That creates problems for traders and investors alike, but in both cases, there are things you can do to make yourself mentally ready for what looks like being an extended period of unpredictable moves.
1. Understand Volatility: There is a common misconception as to the nature of volatility that is perpetuated by media commentary. It is not just downward movement. That is simply a market decline. Volatility is sudden, sharp movement in either direction, and usually in both. Since the end of January, stocks have moved more than five percent after changing direction on five different occasions and, based on early indications this morning, look like they are about to perform another, similar turnaround.
For many people that is unsettling, but if you think about it logically, it should be reassuring. It makes it extremely likely that big losses will be followed by big gains and understanding that makes it a lot easier to sit through all the chaos without trying to pick tops and bottoms.
2. Take Out Some Insurance: I have touched on this subject in previous articles, but it is worth repeating. You will hear many people say that individual investors should avoid leveraged products, particularly of the inverse variety. They claim that they are too hard to understand and do not truly reflect the inverse of moves. That, however, is both condescending and irrelevant.
You shouldn’t buy something like the ProShares UltraPro Short S&P 500 ETF (SPXU) in anticipation of exactly reflecting three times every move down in the index, nor in anticipation of making a huge amount of money. Whether you understand the inner workings of the product or not, what it does is provide something green when your portfolio update is otherwise a sea of red, and enables you to say, “See, I saw this coming and was prepared.” Once again, what you are doing is trying to make sure that you are not being panicked out at or close to the bottom.
3. Have A Consistent View: If you look back at the history of the stock market, one thing becomes clear. Even the biggest, scariest drops will at some point in the future be mere blips on the chart. That doesn’t mean, however, that every move should be ignored in every situation. If you are close to your investing goal, be it retirement, college tuition or whatever, short-term declines can still derail your plans.
In those circumstances it makes sense to move to cash, but you should do so quickly and decisively. The nature of volatility means that your decision to do so could lead to some missed opportunity, but that is the price you pay for peace of mind. If your ultimate goal is still a long way off, however, call up a 10-year chart for a major index whenever you feel like selling everything.
Ten years ago, we were in a real crisis of historic proportions, yet with hindsight it is clear that selling into that decline, even early on, was a mistake for long-term investors.
Whether you decide to sell or ride it out, though, the important thing is to make a determination early and stick to it, to avoid getting whiplashed as you sell low and buy high.
It should be clear by now that mentally preparing for volatility is fundamentally about putting yourself in a position where that ultimate mistake can be avoided. Remember that those on T.V. and even some of us who use the written word have an interest in drama. If every drop is portrayed as a potential disaster and every jump as the start of a massive bull market, we attract more clicks and viewers, but if you as an investor believe it, you will do massive damage to your account balance.
Most investors understand that the aim is to buy low and sell high, yet the evidence shows that they consistently fail to do so. Understanding the two-way nature of volatility, having something to point to in your account that makes money on the way down, and acting early and with consistency when circumstances dictate will all help to control the psychological drive to do the wrong thing, and that is the key to surviving volatility.