What to Do—and Not to Do—When Volatility Strikes

Between the escalating situation in Ukraine and stocks’ entering their first correction (short, sharp, sentiment-driven -10% to -20% decline) for this bull market, the urge to “do something” can beckon strongly. But for investors, reacting to these items is usually counterproductive—and costly. Your portfolio’s performance during (and your personal reaction to) volatile spells may reveal some positioning weaknesses that you would be wise to address, but this is best accomplished in a measured, forward-looking manner, not a knee-jerk move when stocks are falling. With that in mind, here are some dos and don’ts to help you get through a difficult stretch of headline worries and rocky markets.

Do: Above all, keep a longer-term perspective. We think your asset allocation—the mix of stocks, bonds, cash and other securities in your portfolio—should be based on your long-term goals, time horizon, ongoing needs and comfort with volatility. Bouts of negativity alone shouldn’t cause you to veer from it. Ideally, your asset allocation should be one with a high likelihood of reaching those goals over time regardless of the ups and downs along the way.

Keep in mind what your asset allocation’s components are there to do. If you hold some cash, it is probably there for cash flow needs, emergencies and known, upcoming purchases. Having some bonds can reduce the magnitude of portfolio swings and, therefore, the likelihood of having to take scheduled withdrawals after a large drop. Stocks are usually there for long-term growth, which is the reward for their higher expected short-term volatility. For most folks, these can work in concert toward long-term goals.

Veering from your asset allocation is perhaps the biggest risk you can take, as it moves you off your long-term path. If your goals have changed, then maybe a different asset allocation is in order. But that should be unrelated to volatility, in our view, unless your comfort with volatility is so low that you risk making a reactionary error. This is something to consider carefully, not decide in the heat of the moment.

Do: Distinguish between normal volatility and bear markets. Short-term volatility is unpredictable and includes corrections that can occur for any or no reason. Contrast this with bear markets, which are typically long, fundamentally driven declines exceeding -20%. Unlike corrections, we think it is possible to identify bear markets early on and avoid some downside. Yet if you are wrong and sell well into a correction, you risk getting whipsawed—locking in the decline and missing the recovery that follows.

Positioning for a bear market should be a forward-looking decision—not a reaction to past declines. In our view, it is beneficial to do so only if you identify a bear market before the bulk of the downside has passed—you see a strong likelihood of substantial further declines. In our experience, this can manifest in one of two ways. One, after stocks finish climbing the wall of worry and euphoria blinds most to deteriorating economic conditions. Two, a huge but broadly ignored negative development capable of wiping a few trillion dollars off global GDP looks very likely to materialize. Here, “broadly ignored” is the key—risks everyone discusses are probably reflected in prices already.

Bear markets usually start gradually with rolling tops—slipping on average by about -2% a month—and lull many into complacency. They generally don’t announce themselves with big, sudden drops that spook everyone. About one-third of a bear market’s decline occurs during the first two-thirds of its duration. Then, the bulk of its decline takes place in the last third. We think the slow start is what makes it possible to cut out a chunk of the downside.

Note though, even if you don’t identify a bear market in time to take a defensive stance, it shouldn’t automatically put your goals out of reach. Participating in a bear market isn’t desirable, of course. Yet bull markets always follow bear markets, and stocks’ long-term returns include all the bear markets along the way. Therefore, being invested in bear markets shouldn’t put long-term growth out of reach as long as you participate in bull markets, which far outweigh bear markets in time and magnitude.

Do: Check that your portfolio is well diversified. Make sure your portfolio isn’t overly concentrated in any one security, sector or country. Remember, you can always be wrong. If that concentration doesn’t work out, it could be a severe setback. Staying diversified makes sense in either rocky or calm periods, but viewing a pullback as a stress test can help you identify areas to address.

To assess whether you are diversified sufficiently, check your holdings against your benchmark—ideally, a broad, market-cap weighted index with a long performance history, such as the MSCI World Index. If your portfolio is down (or up) much more than your benchmark, that could be a sign of misalignment. Check that your sector and regional weightings aren’t far out of line with the benchmark’s composition, and check for individual holdings that make up a much larger share of your portfolio than they do the benchmark. If you see issues, taking immediate action in the heat of volatility may not be wise, but at least you can develop a plan to execute when the time is right.

Don’t: Buy portfolio ‘insurance’ like alleged low-volatility ETFs or option strategies designed to dampen market swings. You will likely be paying a premium for something that might not work as advertised—and, even if it does, it would likely limit your returns in an up market. If it detracts from your portfolio’s long-term returns, the momentary peace of mind it may provide isn’t worth it. Markets are efficient. There isn’t any magic product with high, equity-like returns that aren’t commensurate with its risks—an investment rule to always remember.

Don’t: Dive into supposed safe havens. Similar to products marketed as portfolio protection, alleged safe havens like gold, real estate or other assets that many think will hold their value in tough times often don’t deliver. They can fluctuate as much as or more than a mix of stocks and bonds, without contributing anything to your portfolio. Also, they can be illiquid, adding to investment risks. Keep in mind the tax considerations, too, which may involve complicated planning and paperwork—another risk.

Avoiding volatility at all costs is antithetical to the very concept of investing. We find a more helpful way to look at the markets’ sometimes wild gyrations is to reframe them: Short-term volatility is the price you pay for long-term returns. This doesn’t mean you shouldn’t manage volatility along the way. But that is what bonds are for if the ups and downs of stocks are too much for you or are inconsistent with your goals and needs. You will be hard pressed to find a better substitute or alternative, in our experience. There aren’t any shortcuts when it comes to investing.