Volatility can be difficult for any investor to stomach, and it's genuinely frightening to see years of savings wiped out by fluctuating asset values. After the tumult in early 2020, many investors are on edge about the impacts of political division, rising COVID-19 cases, and lingering high unemployment. Anxiety might be understandable right now, but investors should take every precaution to remove emotion from their financial decision making. There's a science to portfolio construction and volatility management that should be followed to achieve the best possible outcomes.
The Chicago Board Options Exchange's CBOE Volatility Index, or VIX for short, is one metric that investors use to gauge the level of volatility in the stock market. The VIX jumped above 66 in March 2020, its highest level since 2008.
The VIX opened November 2020 at 37 and has since dropped to 23.5. This is actually among the lowest levels since February, but still meaningfully higher than the average daily closing values that have generally hovered in the 15 to 17 range for the past decade. It is certainly fair to say that volatility is elevated, but it is far below crisis levels. Fearful investors should find some solace in that fact.
Volatility is a necessary part of equity investing
Shares fluctuate in value on the secondary stock market. Volatility is often considered synonymous with risk in a diversified portfolio, and that makes sense from a practical standpoint. The actual risk in a properly diversified basket of equities is that the holder will be forced to sell and realize losses at a time when returns happen to be negative. However, stocks are generally intended to drive asset growth, which is not possible without upside volatility. It comes with the territory.
Image source: Getty Images.
When analysts talk about the VIX, it is generally an analysis of short-term market conditions, as the options the index looks at expire within the next month. Investors with sound long-term plans need to understand how short-term volatility interacts with long-term trends and allocate their portfolio according to proven methodology.
If you aren't cashing out soon, you should generally ignore the VIX
The stock market ultimately tracks the financial performance of companies in every industry around the country and the world. As the economy goes, so too do market indexes over the long term. The global economy has trended relentlessly upward over the past few centuries, with a handful of temporary interruptions. The market has similarly followed suit. Bubbles and bear markets wreak periodic havoc, but the long-term trend in equities has been upward. Ten-year rolling returns are overwhelmingly positive, while 15-year windows have never seen negative returns from the S&P 500.
Investors with time horizons exceeding 10 years can therefore be highly confident that a diversified portfolio will rise before they sell. Short- and medium-term market fluctuations should not be a concern, since those paper gains and losses are unrealized. If the VIX is high, and a 35-year-old's IRA drops 15% tomorrow, it should not impact their current consumption behavior or their lifestyle in retirement.
Investors who sell out of long-term positions during rocky times can incur massive opportunity costs. There are no doubt people who had no immediate cash needs, yet moved fearfully from equities when the VIX spiked in early 2020. They effectively sabotaged themselves by losing out on the remarkable rebound. Allocation in portfolios with long time horizons should be limited by the results of a risk tolerance questionnaire, but they should actually embrace volatility.
Retirees are in a slightly different boat
Retirees shouldn't panic either, but their relationship to volatility needs to be different due to their time horizon. An account that is overexposed to equities can ruin a financial plan if there are market swings prior to or in the early stage of retirement. Those investors would be forced to sell from a down account to pay for their basic needs and lifestyle, effectively locking in their losses.
Volatility is not a dire threat to retirement portfolios that have the proper ratio of bonds to equities and a healthy balance of different equity categories. Retired investors who have not allocated based on time horizon and risk tolerance should immediately do so.
Retirees who still worry about volatility despite having followed sound allocation rules should find comfort in the decades of observations and science that have informed portfolio theory. At most, anxious investors should modestly reduce volatility by accelerating planned rotations for the next year or two. Short-term market conditions should not dictate major changes to allocation.
