What is Market Volatility and How Can You Protect Against It?
If anyone told you on January 1, 2020 that toilet paper was about to become a precious commodity, you wouldn’t have believed them. But, of course, that is exactly what happened when the pandemic hit, lock-down began, and panic-buying set in.
So, what does this have to do with financial markets? It illustrates that our world is unpredictable. And, financial markets are constantly reacting to the world. Share prices are always fluctuating up and down. What’s expendable can suddenly become valuable, and what’s valuable can suddenly become almost worthless. And how much the overall stock market moves is referred to as market volatility.
The market will usually move up and down around 1%; this is considered normal. However, the market is considered volatile if share prices start moving up and down more than their average. This can sometimes lead to frantic buying and selling. With some understanding and planning though, you can protect yourself against market volatility.
What is Market Volatility?
Volatility reflects the constant movement up and down (and back again) of the stock market. It’s a measure of how consistently an index or investment has performed, or not, compared with either a benchmark or its own average.
Market volatility is often referred to as the market’s “fear gauge.” Why? Because volatility can increase when external events create uncertainty. The two most recent examples of these events include the onset of the COVID-19 pandemic and the 2020 presidential election.
What is VIX?
The metric VIX refers to the measurement of the expected volatility for the entire stock market over the next 30 days. Created by the Chicago Board Options Exchange (CBOE), this measurement can tell you a lot about the safety of your investments.
How VIX is calculated is much too complex to explain here; however, all you need to know is that the more volatile the VIX is, the higher the risk of your investments. Or rather, the more share prices are expected to move up and/or down.
What is Beta?
For individual stocks, volatility is often encapsulated in a metric called Beta. This measures a stock’s historical volatility relative to the S&P 500 index. In simpler terms, it’s calculated by looking at how much an asset's price deviates from its average price.
A Beta of more than 1 indicates that a stock has historically moved more than the S&P 500. A Beta of less than 1 implies a stock is less reactive to overall market movement. There’s also the rare case of a negative Beta, which means a stock will move in the opposite direction of the market.
How Can You Protect Against Market Volatility?
The worst thing you can do is panic sell after a big market drop. In fact, according to analysts at the Schwab Center for Financial Research, in the periods since 1970 when stocks fell 20% or more, they generated the largest gains in the first 12 months of recovery.
So, the question then becomes: how do you protect your portfolio against market volatility?
Portfolio Protection Strategies
Diversify, Diversify, Diversify
Diversification is a cornerstone of modern portfolio theory (MPT). You diversify your portfolio by owning a large number of investments in more than one asset class. This means your portfolio should include some bonds and money market funds along with your equity mutual funds. Your investments should also be spread out across a number of geographical regions and encompass more than one investment style.
Stock portfolios with 12, 18, or even 30 stocks can alleviate risk. Why? Because in a market downturn, a well-diversified portfolio will outperform a concentrated one.
Stop loss orders protect against failing share prices. It is an order to buy or sell a certain stock once it reaches a certain price. While a stop loss order can protect your portfolio from rapidly changing markets, they can make temporary losses permanent. Your stops, if you choose to use them, should be well-planned.
There are two types of stop loss orders. Hard stops trigger the sale of a stock at a fixed price that doesn’t change. Trailing stops move with the stock price and can be set in terms of dollars or percentages.
Companies with a strong history of paying dividends typically uphold that practice even during periods when their share value drops. By utilizing dividends you can set yourself up to have money coming in quarterly which can offset potential losses in your portfolio.
You’ll want to focus on Dividend Aristocrats. These are companies that have consistently raised their dividends for at least the past 25 years.
Market Volatility Takeaways
Essentially, navigating market volatility is a little bit like dealing with any volatile situation; plan ahead, stay calm, and make no sudden moves.
It also helps to get some expert advice! While market volatility will always be a factor, working with a financial expert who can help you be informed and well-prepared will allow you to weather any situation...even a run on toilet paper.
For more information on diversifying your portfolio and protecting yourself from market volatility, reach out to our experts at Paradigm Financial Group Inc. at 610-422-3530.