2020 has been a year that Wall Street and the investment community won't soon forget, and there are still more than 10 weeks to go.
The coronavirus disease 2019 (COVID-19) pandemic has spurred volatility in the stock market. In the first quarter, the benchmark S&P 500 (SNPINDEX:^GSPC) shed 34% of its value in just 33 calendar days, with the CBOE Volatility Index registering its highest reading in history.
On the flip side, we also witnessed a ferocious snap-back rally in equities. It took less than five months for the widely followed S&P 500 to regain everything that was lost and even hit new highs. This is the quickest we've ever seen the stock market peak after touching a bear market low.
As a whole this year, the S&P 500 has recorded 12 of its 15 largest single-day point increases, as well as 12 of its 15 biggest single-session point declines.
Investors should do the following five things when stock market volatility strikes.
1. Relax -- volatility is normal
It's easier said than done, but the first thing investors should do when stock market volatility rears its head is relax. Volatility is always present in the stock market, and what seem like wild vacillations are actually far more common than you might realize.
Focusing solely on the downside, which is when volatility is most noticeably present, the S&P 500 has undergone 38 corrections of at least 10% since 1950. That's a double-digit correction every 1.84 years on average.
If we include smaller but nevertheless notable corrections of at least 5.8%, the frequency increases. Over just the past 11 years, there have been 15 corrections, ranging from the nearly 6% decline in 2013 that lasted 34 calendar days to the 34% swoon in the first quarter of this year that took 33 calendar days. We've seen ultrashort corrections, such as the 10.2% decline in the first quarter of 2018 that took 13 calendar days, and long ones, like a 157-calendar-day drop in 2011 that shaved 19.4% off of the S&P 500.
We're never going to know ahead of time when or why stock market volatility will strike, but it's far too common to get worked up about.
2. Reassess your investment theses
While you should assess your portfolio regularly even during times of stability, a vacillating market is a good opportunity to reevaluate your investment theses. In other words, ask yourself the following question: "Are the reasons I bought into this company still applicable today?" More often than not, the answer to this question will be yes. If that's the case, there's no need to consider running for the exit when a sell-off occurs in the broader market.
Periods of heightened volatility rarely change the long-term outlook for, or have a tangible effect on, the operating model of a publicly traded company. In the rare instance that periods of volatility disrupt your investment thesis, exiting your position could be worthwhile.
3. Maintain a long-term view
If you're buying innovative or time-tested businesses with a long-term mindset, you won't have to sit on the edge of your seat wondering if your initial investment has evaporated over the past couple of hours.
The stock market experiences crazy swings due to emotional investors driving short-term moves in the market (this goes for Wall Street professionals and retail investors). Emotional investing almost always leads to the market overshooting to both the upside and downside in reaction to news events.
The most important figure you should know is 38 for 38. Each of the 38 corrections in the S&P 500 since 1950 has eventually (key word!) been erased by a bull market rally. Over time, the stock market tends to rise. Invest accordingly.
4. Start nibbling
Get your proverbial shopping cart out. Since every broad market correction is eventually erased, any notable dip lower in equities is a proven long-term opportunity to pick up high-quality companies on the cheap.
For example, the S&P 500's September swoon marked the perfect occasion for me to pick up shares of pharmacy chain Walgreens Boots Alliance (NASDAQ:WBA) at roughly 7 times forward earnings. Walgreens has been clobbered by slower foot traffic in its stores and healthcare clinics as a result of COVID-19, but these issues should be relatively short-lived as the company adapts. Walgreens aims to cut $2 billion in annual operating expenses by 2022, has invested heavily in digitalization, and has partnered with VillageMD to put full-service healthcare clinics in up to 700 of its U.S. locations.
When volatility strikes, it's time for investors to start nibbling.
5. Avoid using margin
The fifth and final thing to do is pretty simple: Avoid margin like the plague.
While there are some instances when margin is unavoidable, such as when short-selling a stock, using it as a leverage tool during periods of heightened volatility is akin to trying your luck at the roulette table. The odds are most definitely not in your favor. Not only will you owe interest on what you borrow, but since short-term moves in the stock market are completely unpredictable, you could quickly compound your losses if things don't go your way.
Investing during periods of heightened volatility is a smart move. Just make sure you're doing it with cash that you can afford to lose and don't need for many, many years to come.