'Please Calm Down' Might Not Be The Best Advice For All Investors

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Includes: MINT
by: Ron Honig
Summary

The recent month reminded us the taste of high volatility.

While high volatility can be an opportunity to some investors, it can be fatal to others.

It is an opportunity to sharpen the investment strategy.

The recent month of October was pretty hectic in the markets. Both the equity markets as well as the bonds markets faced major swings in prices. This situation raised the concern among investors that we are doomed to see another “2008 type of crash” coming up soon.

The most common theme is that it is only logical to see a crash after ten straight years of a bull market, and when the conclusion is set, one needs only to look for evidences that support his theory and prove he is right.

Talking to a wide variety of people who invest in the markets, it seems that times like this raise their levels of anxiety and fear which lead them to be more alerted and increase the number of actions they take. It proved time and time again that acting from an emotion of stress does not best serve the investor’s long-term goals.

No one really can tell what the future would bring but one can learn from the historical facts and adopt the right strategy that best fits his own specific situation, according to his goals, age and risk tolerance.

When looking at the graph of the S&P 500 (the blue line below) during the recent month, it seems that in just a couple of weeks it lost all the gains it delivered since the beginning of the year. The graph proves that while the index crawls upwards slowly it breaks down sharply and snaps downwards in aggressive drops. This is only human.

This is nicely proved through the movement of the VIX (the orange line below), which is tending to remain at the range of 10 to 20 points during times of slow incline upwards and jumps to 20 points and above during days of high volatility and quick drops.

When expanding the historical view it seems that during the recent decade volatility tends to raise its head from time to time. High volatility is part of the game in investments. Uncertainties lead to anxiety and anxiety leads to high volatility. Again, it is only human.

The next chart shows the number of days the VIX was higher than 20 points and higher than 30 points. The chart goes back about 30 years.

It is very clear that during the time period between 1990 and 2018 the U.S. faced two major time frames of high volatility. And these time periods were measured in years.

It is interesting to mention here that events that occurred prior to the dot-com bubble burst, during the late 90s, led to high volatility. It was driven back then by worldwide economic instability, especially in the emerging markets.

Eventually, the dot-com crisis led to a 40% drop in the S&P 500 during a time period of three years and it was followed by the 2008’s financial crisis which ended up with a 38% drop in the index within a single year.

When looking at the last five years it seems that 2018 is one of the more volatile years in the recent decade but this was mostly driven by the correction that the markets faced back in Q1’18.

Looking specifically at the number of days when the VIX was higher than 30 points, meaning very high levels of volatility, it seems that we are still far from the high anxiety days of these two recessions that were mentioned above.

The most recent period of extremely high volatility was in the second half of 2015 when the markets were very much concerned about the ability to adjust back to an era of positive interest rate after seven years of zero interest rate.

Could the couple of days in 2018 on the chart imply that we are about to get into a longer period of a roller-coaster volatility? No one can tell and there are many experts that explain why the markets could face a deeper correction and those who think we are just before another rally. In any case, the current situation provides you the opportunity to evaluate your next steps and make sure you possess the proper tools, strategies and mindset that are aligned with your goals as an investor.

It all starts with your goals

There are different types of investors. There are people at the age of 45 or 50 that decided to trim down their working hours, move to part-time or leave the workforce altogether and use their investments to cover their expenses. On the other side, there are people that at the age of 70 still do not believe in retirement and have sufficient income that allows them to avoid touching their savings and probably would not need it for a long time.

Due to the low interest rate era, investors that were looking for decent returns were pulled into the equity markets. This was a good decision if one understood the risks and the potential downside of this decision. Moreover, as times go by, people’s goals do change and the investment strategy during the time of wealth creation could be very different from the strategy when using the wealth, at least from risk management perspective. It very much depends on one’s horizon.

The strategy would be very different for the different types of investors. Investors with a long horizon and surplus income that are constantly contributing to their wealth build-up should not be disturbed by the ongoing volatility in the markets. These investors should be less worried about the market instability; but on the contrary, they might have opportunities to take advantage of this correction and add shares at attractive prices.

The strategy to constantly add to your position across time proved to be very successful at the end of the day.

On the other end, people who are highly dependent on their portfolio to supply their day-to-day needs and cover their expenses should be very cautious and should take steps to reduce their dependencies. Those are the people with the short horizon, using strategies like the “4% retirement rule” and constantly sell shares to maintain their standard of living.

I personally know investors who use this strategy while investing in Technology stocks. These type of investors should realize that high volatility periods are very risky to their long-term strategy as they could easily face a situation when they are forced to sell at prices which are very low and by that jeopardize their entire financial model.

Investors who obtain this type of strategy should therefore conclude that they must control the built-in risk and, for example, have a bucket of cash or cash equivalent like PIMCO Enhanced Short Maturity Active ETF (MINT) that would be used as an alternative to selling shares.

We saw that high volatility periods could last for relatively long periods of time. Hence, I would suggest to maintain an 18-24 months’ worth of expenses in low-risk investment vehicles. This proposal is not relevant to people at the age of retirement only, but to anyone who is leaning on his equity holdings to support his ongoing expenses.

Those who follow me know that this is one of the main reasons I am so keen about building a portfolio that includes dividend-paying stocks. The dividend mechanism allows me to constantly generate cash at any market climate and by that keep back situations of being forced to make an action out of necessity.

Conclusion

In the recent decade, investors that were looking for reasonable return were obliged to look for it in the stock market. This move was not necessarily accompanied by a clear understanding of the risks that the equity markets possess, which among others include volatility.

The expected interest rate hikes and the accompanied pullback in the bond market might open some opportunities to investors who are counting on their holdings to cover their ongoing expenses to shift some of their wealth to less volatile territories.

On the other end, investors with long horizon should take advantage of these times of high volatility and collect equity at attractive prices.

As always, I appreciate your comments.

Happy investing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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