It's virtually impossible to predict exactly when market volatility will arise. Just when it seems to be smooth sailing, storm clouds can send portfolios reeling. While most investors don’t relish seeing their portfolios whipsaw, there are ways to make the market ups and downs work in your favor.
In simple terms, volatility refers to how much a stock price—or market aggregate—swings up and down. There are times in the investment cycle when markets are more volatile than others—and it often comes in waves. In fact, experts who study volatility have equated the phenomenon to turbulence on an airplane: Investors may experience a smooth ride for an extended period only to hit rough patches.
There are different ways to gauge volatility, including standard deviation, options pricing, or sharp ups and downs on a stock chart. The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, offers a forward-looking view of volatility based on price trends for S&P 500 index options. The VIX is also known as the “Fear Index.” When the price of such “insurance” goes up, it suggests that investors are worried, and that volatility will soon follow. When options prices come down, it indicates that the captain has turned off the seatbelt sign.
While investors generally think of volatility as a bad thing, an investment can be volatile and still pan out over time—assuming you have a plan and stick with it. Here are five ways investors can make market volatility work in their favor.
Stay the Course
Market volatility isn’t necessarily a bad thing for investors—provided you don’t let fear get the best of you.
The ability to ride market ups and downs starts with having a solid foundation and a solid plan. That means a well-diversified portfolio that reflects your investment goals, time horizon and tolerance for risk.
Dollar-cost averaging is a great way to make volatility work in your favor. By committing to invest a certain amount at regular intervals, you will automatically be able to buy on the dips, without trying to time the market. Best of all, dollar-cost averaging can shelter you from the greatest risk of all—human emotion.
Buy What’s on Your Wishlist
Warren Buffett famously said to be “fearful when others are greedy and greedy when others are fearful.” This doesn’t mean investors should abandon dollar-cost averaging into their core holdings, but it does suggest that some investors can attempt to buy on the dips.
Financial advisors recommend carving out a small portion of your portfolio for “opportunistic” investments. When markets are steadily heading higher, sans volatility, build up some cash reserves—or “dry powder” in investor parlance. Make a wishlist of the individual stocks, thematic exchange-traded funds (ETFs) or other assets you might like to own. Then set a price target.
One of the easiest ways to buy on the dips is to put the decision on autopilot by creating a buy limit order in your brokerage account or with your financial advisor. If the stock declines, this order kicks in to buy the security at that price or lower.
Bet Against the Market
Most investors are familiar with the term “shorting the market.” Put simply, this strategy speculates that individual securities, sectors or segments of the market will decline in value.
Short-selling is risky and requires a good deal of experience and capital to execute. Investors will want to consult their financial advisor before considering such a strategy—and then do so via a mutual fund or ETF.
Many investors who go this route will opt for a long-short strategy; managers of these funds have the leeway to own stocks outright (that’s going long) or bet against stocks they think overvalued and poised for decline.
Look into Low-Volatility Funds
Not all stocks move up and down with the overall market in perfect sync. In fact, some stocks (and other securities) tend to hold their course in turbulent times—and others even rise to the occasion.
Enter low-volatility stock funds. The funds, a.k.a. minimum volatility funds, favor utilities, consumer-goods companies, dividend-payers and other stocks that tend to outperform when the market is in duress.
There is a tradeoff for this approach: Owning low-volatility stocks can mean giving up gains when the market is headed higher.
Hedge Specific Risks in Your Portfolios
Most individual investors can ride out market volatility by spreading their risk across a diversified portfolio that includes a mix of stocks, bonds and other securities that makes sense for their risk tolerance and time horizon.
That said, there are cases where investors will want to hedge against specific risks in their portfolios. For example, an individual who has a good deal of his or her wealth tied to company stock that cannot be sold immediately may want to hedge against losses in that sector or the market overall. Similarly, someone who is nearing retirement may want to use some hedging, if only to sleep better at night.
One of the most common hedging strategies is to use put options. Put options bet that the price of a stock will go down, but unlike shorting strategies, puts give investors the option to sell a stock a specific price during a limited time in the future. As with any “insurance” put options can save investors from bigger losses, but they come with premium—that adds up over time.
In the end, there is no single best strategy for managing volatility. As with most areas of investing, the key is to know what works best for your timeline, your risk tolerance and stomach for ups and downs. Whatever the strategy, have a plan and stick with it.