By Adam Harding, financial advisor on NerdWallet’s Ask an Advisor.
Over the last several weeks, there have been plenty of doomsday headlines including words like "Ebola," "ISIS," “bubble territory” and "market correction." Financial markets have responded by punching investors in the mouth — and testing their ability to stick to a plan — while reintroducing a familiar antagonist: volatility.
During periods like this, it's not uncommon to feel like we’re on the brink of a financial apocalypse. However, it's important that you have the right resources to help you maintain the proper perspective and avoid falling into emotional investing, which can seriously derail your long-term plan.
Here are two tools for your financial survival kit:
1. Know the Enemy
Market volatility is the source of much unrest when it comes to our financial lives. We tend to get caught up in the euphoria of new all-time highs and what seems like easy money. But as soon as excessive greed or fears take over, market prices move more erratically than fundamentals might warrant. The result is price volatility.
Perhaps the most valuable tool in understanding volatility is exploring how frequent declines are. Over the last five years, the S&P 500 has seen 14 corrections of greater than 5%, with an average decline of 8.4% per correction. Such movement shows how difficult it may be to “sell out” of the market before one of these decline and get “back in” before the rally starts. It’s nearly impossible.
Abraham Lincoln once said, "Do I not destroy enemies when I make them my friends?" Using Honest Abe’s approach and embracing volatility as a friend might not only help you sleep better at night, but it also could present opportunities to take advantage of emotional price swings driven by greed and fear.
One of the simplest and most effective methods to take advantage of volatile markets is threshold rebalancing. This method utilizes “bands” intended to trigger a rebalance when exposure to a given asset class or investment exceeds a pre-established threshold.
For example, Mr. Rogers has a 20% target allocation to hypothetical fund “XYZ.” Because this particular investment has shown tremendous volatility, Mr. Rogers made a commitment to a rebalancing approach upon buying the investment. His approach is to rebalance his portfolio back to his 20% allocation whenever his allocation falls or rises 2% or more than his target.
In other words, when volatility strikes Mr. Rogers’ neighborhood and the price of the fund falls and its weight in his portfolio falls to 18% or lower, Mr. Rogers would buy the fund to hit his target of 20% while taking advantage of lower share prices. The opposite would be true when the fund rises to 22% or higher.
There are several disciplined approaches that may allow an investor to take advantage of volatility. Be sure to use caution when approaching these strategies, as anything that carries a potential reward typically has a corresponding amount of risk.
2. Keep Your Options Open
When disaster strikes, keeping yourself from having to make a decision is invaluable. Here are a few areas where keeping your options open might help you survive.
Diversification is still the best method of risk management — and no, staying in cash does not eliminate risk.
By avoiding concentration in any one investment or asset class, the likelihood of absorbing the full movement of a market decline is low. Certain asset classes might retain value, while others decline, leaving an opportunity to tactically rebalance into the depressed asset class and take advantage of lower prices.
Spending and Saving
When markets behave erratically, having a prudent spending and withdrawal strategy can be just as important as making investment decisions. Consider the following example:
Jane is a 68-year-old retiree who requires $36,000 per year from an investment account to pay for her living expenses. If her portfolio value today is $1 million, then the annual withdrawal rate is 3.6%, a historically acceptable distribution rate by many standards.
Now, consider the effect of Jane’s withdrawals on her portfolio if her investments decline by 40%. Her 3.6% withdrawal rate jumps to 6%, a level which is considered to be significantly higher risk for long-term stability. Her retirement plan lacks the same level of solvency she previously enjoyed.
The mathematical relationship in the example above may be simple, but the implications are significant. If Jane can avoid having high fixed expenses, then she can ride out volatility and would not be forced to sell investments at depressed values. This alone is reason enough to focus on limiting financial obligations that lead to a high level of fixed expenses.
These tools might not be effective in the zombie-variety apocalypse, but when it seems like the bottom is falling out of the financial markets, just make sure to remember your tools and trust the process. Markets need a healthy dose of volatility to match the fearful with the greedy, and vice versa; it’s up to you to pick which side you’re on.