Coping with market volatility

How to avoid money-losing moves in gyrating markets

During periods when sentiment sours and markets sell off suddenly and steeply, as has happened recently, financial advisors’ phones never stop ringing, with clients asking whether they should sell their funds or switch into something “safe.” Indeed, markets do seem to be signaling a period of weakness, but no one really knows for how long the bearish sentiment will last.

For investors without a disciplined asset allocation plan, the problem really involves a couple of different issues. First there’s the fact that the value of most mutual funds declines during steep market selloffs. Funds with a large equity component (equity funds, equity balanced funds, dividend funds, and so on) are hit particularly hard. Even those funds using option strategies to mitigate risk will feel the sting of market losses.

Investment risk

The fact is that equities are “riskier” than, say, fixed-income investments like bonds, or “safe” investments like guaranteed investment certificates, cash, or cash-like investments such as money market funds and Treasury bills. In return for accepting the greater “risk” of holding equities, you expect a higher return on your investment than you’d get from those “safe” investments, which offer returns ranging from 0% to 1% or 2% annually.

In the world of mutual funds, “risk” can be quantified in terms of a fund’s “volatility.” Volatility is a measure of how much a fund’s return varies in the short-term from its expected average return. This measure of volatility is called “standard deviation.” So a fund whose value never changes from its average return would have a standard deviation of zero (it has no volatility). The higher the standard deviation measure, the riskier the fund is. You’ll find this measure listed for each fund in leading fund data services, such as Fund Library.

Your personal risk tolerance

The second issue – and the more important one – here relates to the amount of risk you personally can tolerate. As I pointed out, equity investments are more volatile than things like GICs (which don’t change in value at all). During periods of steep market-wide declines such as we’ve seen through January, equity mutual fund investments will generally fall in value to a greater or lesser degree, depending on the type of holdings, how actively managed the funds are, and whether the managers use defensive strategies, such as options.

Using the iShares S&P/TSX 60 Index ETF (TSX: XIU) as a proxy for blue-chip Canadian equities, we can see that the ETF declined -7.1% in the two weeks to Jan. 15. By contrast, the iShares Universe Bond Index ETF (TSX: XBB), a proxy for investment-grade Canadian bonds, rose 0.7% in the same period. The difference between the two is striking, and illustrates the typical non-correlated performance between the two asset classes. As far as risk measures go, the 3-year standard deviation of XIU is 2.5, while XBB is 1.2.

In order to invest comfortably in riskier types of assets such as stocks, you have to acknowledge that they can be volatile (that is, they carry a higher degree of risk than bonds) and that there will be periods when they drop in value. There will also be periods when they rise in value, sometimes by a considerable amount. You have to be personally comfortable with those kinds of swings – and no one can tell you what that comfort level is. One way to gauge your risk tolerance is to ask yourself what degree of stock market decline could you live with over a short period: 5%, 10%, 20%? And be honest with yourself.

Switching can be costly

You might think that your portfolio is “diversified.” But if you’re truly concerned enough to be considering switching funds during a market decline (a drastic step), you may indeed be outside your comfort zone.

Your portfolio may be diversified, but if it’s diversified only among equity funds, it’s not really diversified at all. Without an allocation to non-correlated assets such as bonds, your portfolio will immediately take all or most of the losses that come with steep stock market declines.

If you decide to switch investments now, then you have to give thought to what types of funds you’d switch into. There is a time and place for selling a fund investment, and that usually relates to factors like changes in management, drifting style, “closet indexing,” and so on.

Generally it’s not a good idea to jump from fund to fund on market declines – that could cost you in terms of both investment performance and fees and commissions if you’re in funds that have either front-end loads or deferred sales charges. That’s because by the time you’ve sold out and switched, there’s a very good chance the market decline will have already bottomed out.

If you’re bound and determined to do something, at most, you’d want to raise cash and fixed-income holdings and reduce equity weighting within your asset allocation parameters. Before doing anything, though, I’d consult with your financial advisor. What you need is an objective look at your financial situation, some help with determining your real tolerance for risk, and some suggestions for setting up an investment portfolio that is diversified, tax-efficient, that meets your longer-term financial goals, and that – above all – is in your risk comfort zone.

© 2016 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

Coping with market volatility was last modified: February 7th, 2016 by robyn