How to Deal With Market Volatility

Ok, I’m a bit late to the party with a market volatility comment but I had to get through a rather drawn out baby series first

As you might have speculated, I’m a big fan of William Bernstein who wrote the book “Four Pillars of Investing”. One of the main points of the book is the idea that whatever your asset allocation is (ie 50% equities, 50% bonds) , you have to maintain the equities portion of your portfolio regardless of what happens to the market. This is easy enough to do when the market is flat or going up, but when it drops then it gets a lot harder.

His suggestions to accomplish this are as follows:

Study history: If you are familiar with the equity markets then you know that the long term trend is upward which means that regardless of what happens in the short term, over a long enough time period you will get through the ups and downs and achieve a decent positive return. Another part of history that is important to know about is market manias and the ensuing crashes. Knowing the history of these events from the tulip bulb mania of the 1600’s to the dot.com mania of the late 1990’s will allow you to know that the market always recovers and even if you do get caught up in a mania, if you stay invested in equities then you will do fine. Note that that by “equities” he’s talking about a widely diversified portfolio of equities.

One of his examples from the book “Four Pillars of Investing” uses the great crash of 1929 to demonstrate that if someone retired at the peak of the market in 1929 and had mostly equities in their portfolio (which lost 90% of their value), although they would have had a few lean years afterwards, if they had stayed invested in equities then they would have done just fine and wouldn’t have run out of money. If they panicked and switched into bonds or cash after the value of the portfolio went down, then they would have eventually run out of money.

Another psychological point Bernstein talks about is picking an asset allocation that you are comfortable with even in the bad times. He says you are best off having an equity allocation of 50% to 75% with the higher number being preferable in order to beat inflation. However if you can’t handle the volatility and switch out of equities after the markets crash and then wait until they are up again before switching back in, then you are losing money and you should lower your allocation of equities. You are better off with a lower allocation of equities that you can maintain during a market crash rather than a higher equity allocation that causes you to panic in bad times.

Some of my suggestions are:

Don’t focus on individual securities:

If you are going to monitor your investments then look at the total value of your portfolio including cash, fixed income, equities etc. Don’t just look at the individual funds. If you have a diversified portfolio then not everything will have the same loss so the total value is the relevant number to watch. Not all stock indexes dropped the same amount recently and if you have a portion of your portfolio in fixed income or money market funds then they should have held their value (unless of course you own National Bank money market funds).

Put market drops in the proper context:

Keep a record of your historical portfolio balance. You can either include contributions or not for this exercise. Investors who watch their investments closely in an up market tend to remember the highest recent value that the portfolio gets to and when it falls, they compare the new lower value to the recent high. If you keep track of your total portfolio value and write it down say every six months then you can get a more realistic picture of your investments. For example I know that my portfolio is down around 7% from it’s recent high but I also know that it’s still up about 0.5% from the beginning of the year. If I look at my records (I do a yearly performance analysis) then I can see that I’m still up about 15% (not including contributions) from Jan 1, 2006. Taken in that context, the 7% drop is not that big a deal.

Measure the volatility of your portfolio before it crashes:

You can’t have volatility on the upside without having it on the downside as well. There are many advanced mathematical tools to figure out the volatility of your portfolio but one simple rule is to measure how much your portfolio goes up in a good year and be prepared for it to drop that much in any given year. If that amount doesn’t appeal to you then choose a more conservative asset allocation.

If you enjoyed this post then you will probably enjoy Financial Security Quest’s post a couple of days ago pertaining to market timing. There is a good discussion with that post as well between myself, Mr. Cheap and the MoneyGardener.

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