The stock market’s unpredictable tendencies can be a challenge even during the best of times. But what happens when price swings grow abnormally large? To make the right decisions, it is essential for investors to understand how volatility affects them and their investments.
Why Is The Market So Volatile?
Periods when prices fall or rise quickly cause spikes in volatility that take time to revert back to the norm. This can be due to a number of factors. A stock “bubble”, changes in fiscal or monetary policy, geopolitical concerns, and high speed trading can all have a drastic effect on market movements. Depending on the fundamentals behind the movement, these trends can be long or short term. However, almost all short-term trends have one common cause – uncertainty.
But what drives uncertainty? Everything from emotional responses from investors to differing opinions from experts. Investors tend to overreact to specific events in the market, causing a contagion-like episode that spreads from one institution to another. The 24-hour news cycle and differing opinions from market experts also complicates matters. Emotional reactions along with oversaturated financial information drive volatility.
Investment Strategies for Volatile Markets
Investors must understand their personal risk tolerance levels to succeed during volatile times. Remaining disciplined to proven strategies can be effective, but regular audits of your portfolio and adjusting your risk tolerance levels accordingly is also prudent. A conservative approach might call for minor portfolio adjustments while still focusing on the long term. On the other hand, an aggressive risk-taking strategy may focus on capitalizing on the highs and lows of volatile markets.
Investors who want to take advantage of volatile times may consider the following strategies:
- Dollar-Cost Averaging: This strategy is essentially making the decision to be tone deaf to market movements. A fixed dollar amount is invested on a regular basis (usually monthly). By regular market movements occurring between purchases, more shares are bought when the price is low and fewer when the price is high. In effect, the average purchase price is decreased due to volatility.
- Average True Range (ATR): ATR tries to show the commitment of traders. Large or increasing ranges can indicate that traders may continue to bid up or sell down a stock. A decreasing range can suggest waning interest (i.e. less volatility). Utilizing a stock’s range to set a target price can also be an effective strategy.
- Portfolio Rebalancing: This method proposes buying and selling bits of a portfolio to return each asset class to its original proportion. It is an opportune time to rebalance during a market decrease if capital losses need to be harvested to offset gains, or a substantial amount of a certain fund needs to be bought to re-align the portfolio. Conversely, sharp market increases can create an opportunity to peel back on overweight funds at a higher price.
It is the stock market’s nature to be volatile over the short term. Staying informed, understanding your risk tolerance, and sticking to your long-term goals and planning is usually in your best interest.