This is an excerpt from an article written by Morningstar.com contributor John Waggoner, for the U.S. website. It was also carried on the U.K. website.
If you start to whimper just a little bit before you read the market news, it's probably because stocks are more volatile now than they have been since 2011, when oil prices soared, U.S. debt got downgraded, and Justin Bieber released "Never Say Never."
Volatility, of course, is really a euphemism for "scary down days, often in succession." No one complains about a market with wild and crazy gains. But heightened volatility can not only wrack your nerves, it can make you do silly things with your money.
It's no wonder the market feels so volatile. It is. Let's start by looking at the magnitude of recent market volatility. One measure is the CBOE's VIX index, sometimes called the "fear index." In August, the VIX spiked to 28.3, its highest level since 2011. Recently, it has leveled off to 24.8, which is still historically high.
The Indian market too has had its share of volatility. It fell by over 10% in August.
But before you decide to sell all your stocks or make any portfolio adjustment based on recent volatility--ask yourself these three questions:
Is my risk tolerance really what I thought it was?
Investors often feel that they have a high risk tolerance when the markets are stable and rising.
"Now it's time to review what your risk tolerance really is," says Michael Kitces, partner and director of research for U.S.-based Pinnacle Advisory Group. "Did you fool yourself into thinking you had more risk tolerance because you were underperceiving the risk?"
If the market's volatility is truly terrifying you, then you need to readjust your portfolio to a level of stocks that will let you sleep at night.
When will I need my money?
If you're investing for a retirement that will start in 10 or 20 years, then sharp intraday moves shouldn't concern you.
Volatility reached a fever pitch in 2009, but selling your stocks then would have been a terrible idea. The S&P 500 has gained an average 17.05% a year since the market's bottom in 2009.
On October 27, 2008, the Sensex touched a low of 7,697.39. Two days ago, on October 19, 2015, it closed at 27,364.92. That amounts to an annualised return of almost 20%.
Is it really that bad?
Measured by the daily spread between high and low prices--yet another method for gauging volatility--the stock market is relatively calm, argues Howard Silverblatt, senior index analyst for S&P Dow Jones Indices. The S&P 500 was more volatile in nine of the past 15 years this century.
Nevertheless, it's nerve-wracking to discover that stocks tumbled more than 3% in a day--as did they on two consecutive days in August. After all, the stock market often becomes more volatile before a major bear market.
In India, the Sensex dropped by 1595 points (closing) between August 21 (Friday) and August 24 (Monday). It is now back to 27,000 levels (closed at 27,306 yesterday).
The effect of volatility on retirement investors
If you're nearing retirement--or in retirement--then you have good reason to be nervous. Taking withdrawals in a bear market will draw down your account faster than you'd probably like. If the market falls 10% and you take a 4% withdrawal, your account will be down 14%--a clearly unsustainable rate.
If you're nearing retirement, then a widely diversified portfolio is your best friend in a volatile market. You'll want cash on hand, both to cushion downturns and to use as a buying reserve when stocks are cheap.
You'll need bonds, too.
Christine Benz, director of personal finance at Morningstar, says that "even though bond prices could fall in certain scenarios, high-quality bonds will tend to hold up much better than stocks when investors are nervous about the economy. When stocks dropped in the U.S. in the third quarter of 2015, for example, high-quality bonds were a rare pocket of positive returns," she says. "Just be careful not to overdo it with lower-quality bond types. Their yields are higher than high-quality bonds, but they will tend to perform more like stocks than bonds."
If you're a retiree, having a cash cushion is probably your best response to increased volatility. You want a pool of money to tap when the stock market is on its worst behavior. Tiny returns are better than big losses.
"Having a cash cushion to meet near-term living expenses can provide valuable peace of mind in tough markets," Benz says. A cash buffer can also help you regroup if something derails your cash flow strategy; for example, many dividend-focused investors were scrambling when banks cut their dividends during the financial crisis. You don't want to go overboard, because cash is a losing proposition once inflation is factored in," she says. "Enough to cover six months to two years' worth of living expenses is plenty."
Volatility--at least if it's on the downside--is about as much fun as a kidney stone. And while it's the market's risk that also gives return, it's hard to think about that if you're nearing retirement or in it. While you should never sell out of panic, it always makes sense to readjust your portfolio according to your goals--and a newfound sense of what risk really means.
