Recently the stock market experienced steep declines tempered with rebounds. Investors were left reeling from this sudden volatility. But what exactly is volatility? What caused it to occur? And what can you do to help protect your investments?
It’s been just over one year since the Dow Jones approached 20,000 points. At that time we were all wondering if it had hit its peak or if it would keep rising. It was the latter, as week after week U.S. markets seemed to hit new record highs, while volatility remained near record lows. As this pattern persisted, it was easy to become complacent. But all that changed in February when volatility hit the market.
What is Volatility?
When referring to the stock market, volatility is essentially the ability for market prices to change rapidly and unpredictably. Volatility is often measured by the VIX, which you’ve probably heard about in the news lately. The VIX, first introduced in 1993, is the symbol for the Chicago Board Options Exchange’s volatility index. It’s widely used as a measure of market risk.
How does it work? The VIX calculates risk by taking the price of options on Standard & Poor’s 500 Index (a leading indicator of U.S. equities) and estimating how volatile those options will be (i.e. how much their prices will fluctuate) between now and their expiration dates. The historical average of the VIX is around 19. To put this into perspective, 9.14 is the VIX’s lowest close. That occurred November 3, 2017. The first week of February 2018, the VIX jumped to over 37!
Although market volatility can make you, as an investor, uneasy, it’s a normal part of the investment cycle. On average, a 5 percent adjustment to the market occurs about every 7.2 months and a 10 percent correction occurs about once every 26.1 months. So, don’t make any rash investment decisions!
What’s Caused The Recent Volatility?
Many experts have speculated about the causes of the recent spike in volatility. Some point to concerns about inflation increasing faster than expected. This puts pressure on the Federal Reserve to raise interest rates at a more rapid pace.
In turn, the increase in interest rates causes U.S. bond yields to rise. This could become a catalyst for some investors to sell stocks and put their money in the more attractive bond market, driving the stock market lower. In fact, this process has already begun. The U.S. 10-year Treasury yield has more than doubled from its July 2016 low of 1.3 percent to a four-year high of 2.9 percent on February 12, 2018. Higher interest rates also increase the odds of an economic slowdown, which is bad for the stock market.
But other factors play into the volatility we’ve recently experienced. One is the scare surrounding the potential government shutdown. Another is investment strategies. Some trading tactics involve computer algorithms that trigger buying or selling during times of sharp moves up or down in the market, amplifying the volatility.
What You Can Do?
If you are a long-term investor, the best strategy is to stay calm and stick to your plan. Trying to determine the timing of the market highs and lows can be detrimental to your portfolio. Times like these are a good reminder for both short-term and long-term investors to review their accounts’ risk tolerance and allocation.
Whether the stock market is volatile or remains steady, changing personal circumstances may influence your strategy. Several years ago you may have set up an aggressive plan that takes on higher risk. And that plan likely served you well. But now, maybe you’re buying a new home, expecting a child or nearing retirement. Your risk tolerance in these situations is not going to be as high as it was previously. Once you’ve evaluated your current risk tolerance, assess your portfolio’s allocation to ensure you have the proper exposure.
If you’re an investor, volatility can be a painful thing to experience. But volatility is a normal part of investing. Markets will drop from time to time, but if you have constructed a well-diversified portfolio and have a concrete financial plan, you can ignore the fear-based chatter and focus on your long-term goals.
Austin Stagman is an Investment Analyst with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at bedelfinancial.com or email Austin.