Do You Have a Strategy for Volatility?

On a walk with my dear, departed yellow Lab a few years ago, my typically inquisitive girl walked home like the best-trained canine I had ever seen--eyes on the road, head held high, a spring in her step.

As this was a striking contrast with our usual meandering walks, it dawned on me that something could be up. I proceeded to stick my whole hand in her mouth (don't judge; my fellow dog owners will understand). Out came an entire, intact brownie that, unbeknownst to me, she had inhaled from the sidewalk on the way home. She had thought it wise to not call attention to herself or her prize so she could savor the chocolate-y goodness once we were safely home, away from my prying eyes.

Of course, the market doesn't have a mind of its own, in contrast to my pet's rather sharp one. But the very tranquil period of stocks that had prevailed until today's market drop brought that incident to mind. Everything seemed so calm; stock market volatility had been exceptionally--and pleasingly--low. But that can't possibly last, can it? And with big market swings seeming so unfamiliar, will investors know what to do when serious volatility does eventually materialize and sticks around for awhile?

Equilibrium, Technical Factors, Or ... ? Low volatility--unlike big up-and-down swings in stocks--isn't something that most people notice. But big gyrations in the market have definitely been low so far this year. As Morningstar's Dave Sekera discusses, the CBOE Volatility Index (the "VIX"), often considered a proxy for investors' concern for near-term volatility, recently fell to its lowest level since 1993.

An article in The New York Times described this year's low volatility in a more intuitive way, noting that the S&P 500 had only experienced a 1% swing on a handful of trading days so far this year. Meanwhile, the S&P 500 gained or lost at least 1% on 29% of the trading days in 2015 and 19% of trading days in 2016. The tranquil market environment of 2017 is particularly confounding when you consider just how much uncertainty investors are facing today: In addition to the news flow from Washington, investors have questions about healthcare and tax policy under a Trump administration, as well as how aggressively the Federal Reserve is apt to take action on interest rates.

Theories abound about why investors seemed to be shrugging off these issues, at least until recently. Of course, the economy is reasonably strong, inflation is under control, and interest rates are low--a confluence of factors that investors generally welcome. One economist has posited that the market includes a healthy mix of bears and bulls, leading to a state of equilibrium. Mark Mobius, executive chairman of Templeton Emerging Markets Group, believes that investors' immersion in social media is drowning out actual market-moving news. Meanwhile, Bloomberg reports that technical factors--specifically hedging by large dealer banks--is working to suppress volatility.

Should Everyone Sit Tight? The worry about a period of ultralow volatility like the one that has prevailed thus far this year, however, is that it isn't likely to last. And that could happen just as some investors have been lulled into a sense of complacency about their equity holdings. Investors got a taste of how such a jolt would feel today, when the S&P shed more than 1% of its value; smaller-cap stocks fell even further.

Investors are often exhorted to do nothing when the market drops—and that's certainly miles better than getting into a defensive crouch that you may not know how to get out of. But doing nothing isn't advisable in each and every situation—for example, pre-retirees whose portfolios are too risky should take steps to de-risk them, never mind that the market has fallen a bit.

What follows is a short list of defensible strategies to employ amid volatile markets.

1. Know the difference between risk tolerance and risk capacity. Amid the long-running equity bull market, many investors have lost sight of the difference between risk capacity and risk tolerance. You hear much more about risk tolerance--your ability to psychically manage big losses in your portfolio. How would you feel if your portfolio lost 10% or so in a given week or month? Coming through a period of low volatility, many investors are apt to rate their risk tolerances as high. Because they haven't experienced big losses recently, they've forgotten what it felt like to see their balances shrivel by 10%, 25%, or even more.

Risk capacity, meanwhile, requires you to ask: Does this market sell-off have the potential to disrupt my plan? For investors with many years until they'll need to spend their money, the answer is a resounding no. (That's why you so often hear the blanket advice that investors should do nothing when the market drops.) Investors with many years to retirement have very high risk capacities, meaning they can recover and regroup from losses and it won't affect their plans.

For investors getting close to retirement, on the other hand, risk capacities are lower. Big market drops just prior to retirement can force them to delay their retirement dates or settle for lower withdrawal rates than would have been the case if their portfolios were better diversified and didn't take such a big hit prior to retirement. Indeed, I'd argue that many investors closing in on retirement have high risk tolerances but lowered risk capacities, and that mismatch can cause problems. This article takes a closer look at risk tolerance and risk capacity, and why you should give the latter more attention.

2. Assess portfolio allocations. In strong markets like the bull market that has prevailed since early 2009, most investors tend to leave well enough alone. But if you haven't reviewed your portfolio's allocations recently, use the market volatility as an impetus to do so. A hands-off portfolio that was 60% equity/40% bond in early 2009, for example, would be 80% equity/20% bond today--and meanwhile you're eight years older. That means that rebalancing is in order in many situations--to help align your portfolios' allocations with your risk capacity. This article takes a look at why rebalancing protocols should vary based on whether you're an accumulator or closer to drawing down your portfolio.

Morningstar's Lifetime Allocation Indexes and high-quality target-date series like those from Vanguard or BlackRock can provide reasonable benchmarks for asset allocations at various life stages. For retirees, I'm a big believer in holding one to two years' worth of living expenses in liquid reserves, alongside a long-term portfolio composed of stocks and bonds. This article outlines the bucket approach to retirement portfolio management, a key virtue of which is helping tide you through tough markets without having to raid your long-term assets.

3. Look alive for opportunities. Finally, investors who have been concerned about high equity-market valuations may use a volatile market environment as a reason to go shopping. They can do so either directly, by compiling a watch list of stocks they'd like to scoop up at the right price, or indirectly, by owning a value-oriented mutual fund or two in their portfolios.

Another small silver lining of extended market sell-offs is that tax-saving opportunities can present themselves. Investors in taxable accounts may be able to trim stocks and funds purchased when prices were higher, thereby unlocking tax losses. In a similar vein, conversions of Traditional IRA balances to Roth are often best executed in weak markets rather than strong ones, because the taxes due upon conversion depend on the account's value.