With the recent events in the markets I figured this would be the perfect time to talk about market volatility. This is an important concept to understand so you know how to protect your portfolio from volatile market conditions.
What is Volatility?
First, let me start with explaining what volatility means when discussing individual investments. Volatility is when a investment has a large price fluctuation in a short amount of time in either direction. This is when a stock seems confused on which direction to go, resulting in a lot of movement (up, then down, then back up, then down again).
Higher volatility normally correlates to a riskier investment. Safer investments tend to have smaller price fluctuations.
Bad news, missed sales, size of the company, and pending lawsuits can all cause volatility in a particular stock. The stocks Beta will tell you how risky the company is when compared to the market as a whole. (Learn more about determining the riskiness of a stock – read my article How Risky is a Stock).
So what is Market Volatility?
Market volatility is when the market as a whole is experiencing volatility – affecting almost all stocks. This happens when a major event occurs that affects all industries alike.
For example, the most recent historic event that took place just last week on June 23, 2016 was the UK voting to leaving the European Union (Brexit), causing one of the biggest sell off of stocks in history! Two Trillion dollars left the market…TWO TRILLION DOLLARS! Worse than the sell off during the stock market crash of 2008, when $1.9 trillion disappeared from the markets.
The Brexit vote shocked the markets because most investors didn’t think it was actually going to happen. An economical event like this causes panic in the market, so people sell their stocks in fear their investments will drop in value.
CBOE Volatility Index (VIX)
The VIX is how market volatility is measured and tells you how risky current market conditions are. The VIX index is a gauge of fear/uncertainty in the financial markets.
When the Brexit vote prevailed and shocked financial markets throughout the world, the VIX spiked 50% in just one day! At the same time, the stock market tanked due to a historically huge sell off of stocks in the market.
How to Reduce Your Exposure to Market Volatility
- Diversify – Diversify your investments by investing in bonds, cash, and fixed income securities. When the stock market’s returns are dropping, fixed income securities become more appealing to investors because of their fixed return.
- Asset Allocation – Make sure your investments are set up to your specific needs. If you are retiring soon, you can’t afford a huge drop in the market if your money is in stocks. Rethink your asset allocation and diversify your investments (as stated above).
- Invest in Gold – Gold is another good way to diversify. Gold is a safe haven investment in market uncertainties when market risk runs high. If markets are dropping, gold is normally going up. There are different types of funds that track the price of gold, making it easier for small investors to invest in it.
- Do Nothing – Some people simply don’t do anything. Keep investing on a regular basis and ride out the market’s turbulence to achieve the average market return in the long term. This might make sense for a young investor who has a long investment horizon before them.
How to Take Advantage of Market Volatility
Volatility isn’t always a bad thing when it comes to making money in the stock market. Savvy investors prepare for movements in the market before they happen. And any kind of market movement, up or down, can be turned into a profit. Here are some ways to profit from market turbulence –
- Day Trading – Day traders love big price movements in short periods of time because they can leverage large amounts of money to make a quick profit. This method results in higher tax rate compared to a long term-tax advantage. Either way, if you invest $10,000 in a stock that has a quick 15% rebound and you make a quick $1,500. Even if you pay 39.6% (the maximum income tax rate) in income taxes on it that’s still a profit of $906 in a short period of time.
- Find Opportunities – A Market on the downswing can present opportunities for investors to buy stocks at below average cost. This is when stocks go on sale and you can buy a larger quantity for a cheaper price. This gives you bigger upside potential when the stock rebounds.
- Invest in Inverse Funds – Put your money in funds that have an inverse relationship to the market. This means when the stock market goes down, your fund goes up and vise versa. This way your overall portfolio stays relatively stable. With this option you are essentially shorting the stocks in the S&P 500, so this can be risky.
- Invest in VIX Products – VIX funds will try to match the return of the VIX Index. So when markets are going down, the VIX is mostly likely going up. This can be extremely risky if you don’t know what you’re doing and is only recommended for advanced traders. It’s easy to lose your investment in a short period of time with these investments if you don’t know what you’re doing.
I hope you understand a little more about market volatility and how to protect yourself and maybe even profit from it. Markets can’t always be going up, so being prepared for what’s to come is a very important step in protecting your wealth.