What to Do and What Not to Do When Markets Get Turbulent

One thing investing teaches you is to expect surprises. Coronavirus epidemic? Surprise! Trade wars? Surprise!

Another thing you can learn from investing: Wall Street just hates surprises. When the unexpected arises, the markets can skitter up and down for days and weeks. On particularly volatile days, you could get seasick just watching the market’s moves.

Volatile times don’t mean that the world is ending or that you’ll soon be chipping flints in a cave. Is it easy to invest when the world seems upside down? No. But you’ll panic a lot less if you stick with basic investment principles: Know your goals, be honest about your tolerance for risk, and find ways to soften the blow to your portfolio before investment surprises happen.

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Have a plan

First things first. When markets are going wild, it’s sometimes hard to keep in mind that you’re saving for a goal. If you have a plan for your investments, take a deep breath and review it.

If you don’t have a plan for your investments, it’s a good time to make one. What are you going to spend your savings on, and when are you going to spend it? Make a list of your savings goals, estimate how much they will cost, and know when you want to reach them.

Having a plan helps remind you that lousy market news may offer some positives. It may also calm your nerves a bit, especially if your goals are a few years off. Markets generally recover, and with enough time, your portfolio can take a licking and keep on ticking.

Garden-variety bear markets push stock prices down an average 27% and recover their losses in 13 months, says Sam Stovall, chief investment officer at research firm CFRA. Mega meltdowns, such as the 2007–09 bear market, claw an average 51% from stocks and take nearly five years to recover. Thankfully, there have only been three mega bears since the end of World War II, Stovall says.

This is a good time to ask yourself whether you’re really as tolerant of risk as you thought you were when the bulls were running on Wall Street. You may have thought of yourself as a bold investor, but that’s a harder stance to maintain when stocks are falling.

Check in with the mix of stocks, bonds and cash in your portfolio — your asset allocation — to make sure it’s really right for you. The right blend is one that you can stick with through volatile times.

You’re probably not going to beat the S&P 500 index in a rip-snorting bull market, because you’re not fully invested in the stock market.

On the other hand, you might do less badly in a bear market and be more likely to meet your goal.

“Invest on the plan, not on the market,” says Brad Klontz, a financial psychologist. “If your portfolio went up 8% while the S&P 500 was up 12%, you should be 100% okay with that,” Klontz says.

Don’t have an asset-allocation plan? You can create one yourself, based on an honest evaluation of your goals and risk tolerance. You can also use online programs from your brokerage house or get help from a financial planner.

Otherwise, simply invest your money in a target-date fund, which orients a mix of stocks, bonds and cash toward when you plan to tap your investments and shifts the blend appropriately over time.

A playbook for young investors

If you’re young and retirement is a distant dream, you can be fairly confident in a portfolio with 70% or more in stocks or stock funds. You have time to make up bear market losses. Plus, you’ll be adding to your savings over many more years.

Over the long term, stocks have outperformed cash and bonds. In the 88 10-year periods since 1927, the U.S. stock market has had positive performance 94% of the time, says Mark Bass, a financial planner with Pennington, Bass & Associates in Lubbock, Texas. “And that metric is 100% of the time for 20-year periods,” he adds.

Remember, too, that if you’re investing in the stock market through a 401(k) savings plan with an employer match, you have two bear-beating advantages.

First of all, you’ll be adding a set amount to your portfolio every payday. That means you’ll be buying more shares when prices decline and fewer when they soar.

The technique, known as dollar-cost averaging, tends to result in a lower average cost per share. Second, if your employer matches some or all of your contributions, you’ll instantly make up for some of your losses. Free money is rare, and it’s a good thing.

A warning: Don’t simply invest in the hottest of hot funds, despite your young age. Wall Street is littered with golden funds that suddenly turned to lead. Your core stock holding should probably be a plain-vanilla, low-cost S&P 500 index fund.

You’ll own not only some of the hottest stocks in the world but also some dull, dividend-paying stocks as well. And that’s okay: Dividends have accounted for 37% of the S&P 500’s total return over time.

Tips for seasoned investors

If you have fewer than 15 years before retirement, then you’ll probably want to mix more bonds into your portfolio. Bonds can provide ballast because most times they rally when stocks fall.

The stock market tends to be optimistic; bonds are only happy when it rains. When the economy slows, interest rates fall, and though that lowers yields, it boosts the price of bonds. (Bond prices and interest rates move in opposite directions.)

The classic portfolio mix is 40% bonds and 60% stocks. To add even more stability to your portfolio, you can substitute some bonds with cash — money market funds, Treasury bills and the like. Just be prepared for lower returns.

Be ready, too, to rebalance your portfolio periodically to stay on target and keep risk at bay.

For example, let’s say you want to have 60% of your portfolio in stocks and 40% in bonds, and after a year you have 70% in stocks and 30% in bonds. To get back to a 60-40 mix you must sell some of your stocks and reinvest the proceeds in bonds.

It’s a good strategy even in a down market, says Bill Nygren, portfolio manager of Oakmark fund.

“We would encourage people to look at how the market has moved their allocation and rebalance back to what their target was. I think that is a very healthy way to reduce risk in the portfolio, and, more importantly, reduce the psychological risk that you get scared when the market falls,” he says.

How often should you rebalance? Every six to 12 months is what many planners recommend, though rebalancing after a sharp downturn is fine, too. It may help to set a trigger point: If the stock and bond allocation is off target by an amount you predetermine — more than five percentage points off, say, or seven or 10 — then it’s time to rebalance. Some 401(k) plans will rebalance for you at regular intervals, and some brokerages will also do the same (but you may have to opt in for these services).

Watch your withdrawals. If you’re already retired, be mindful of which type of account you draw from to maximize tax efficiency. Tap money in taxable brokerage accounts first, followed by traditional IRAs and other tax-deferred accounts. Roth IRAs and Roth 401(k)s come last. This strategy gives your tax-advantaged accounts more time to grow.

If you are just starting withdrawals in the middle of a market downturn or a bear market, you could be making matters worse. After all, if you withdraw 5% of your stock fund when it’s down 25%, your account is now down 30%. And to recover from a 30% loss, you’ll have to earn 43%.

Financial planners call this the problem of sequential returns. Over the past 30 years, large-company stocks have gained just over 10% a year, on average, according to Morningstar. But that figure doesn’t mean that the market advanced 10% or more each year. The 30-year return includes some really swell years, such as 2019, when the S&P 500 jumped 31.5%, as well as the monster 2007–09 bear market, the worst since the Great Depression.

To mitigate the sequence-of-returns risk, be sure to put aside money in cash so you can sleep at night during those years when the stock market is stinking up the place.

“It’s literally for when the other stuff is going wacky,” says Bass, the Texas financial planner. “For the people who are in withdrawal mode, depending on their temperament, we’ll keep anywhere from two to five years’ worth of withdrawals as their sleep-at-night money.”

What not to do

Don’t try to time the market. This advice applies to market bottoms as well as tops. For one thing, the stock market’s best and worst days are often just a week or two apart. Missing the 30 best days in the past 30 years shrinks the S&P 500’s average annual total return to 1.8% from 10.1%, according to Wells Fargo Advisors.

Don’t buy trendy new funds. Wall Street tends to trot out funds that suit the market at the moment — red-hot tech funds when technology stocks are on fire, and dull-as-dishwater bond funds when the stock market is in the doldrums.

“Wall Street sells what people are asking for,” says John Rekenthaler, former vice president of research at Morningstar.

That’s not necessarily what makes a good investment. And, because it can take a while to bring a new fund to market, the latest products may land just as an investment trend has ended.

Don’t be a hero. Sudden, sharp declines can make investing in stocks or funds more attractive. But most traders will warn you not to buy in a free-fall: “Don’t try to catch a falling knife” is an old trader’s adage. The market can always go lower. Consider placing a special buy order, called a limit order, for stocks or exchange-traded funds at 10% or 20% below where they are now. You can specify that the order is good until canceled. If the order is filled, congratulations. If it doesn’t fill, then the market hasn’t gone as badly as you thought it might.

Don’t peek too often. Resist the urge to constantly check your portfolio in troubled markets. It can lead you down a path to unfortunate decisions, such as selling at the worst time. It can also wreck your mood as you ponder how much more fun you could have had with the money you just lost.

A PRIMER ON VOLATILITY

Just how volatile are different investment types? Here’s a guide.

Cash: Low, low volatility

Short-term investments include bank certificates of deposit, short-dated Treasury securities and money market mutual funds. They come with little to no risk but also offer very low returns.

Three-month Treasury bills, for example, have returned just 2.5% annualized over the past 30 years. But if you need the money soon — say, to buy a car within the next two years — then cash is your friend. You don’t want the stock market to determine what kind of car you buy.

Bonds: Medium risk

Bonds are long-term IOUs issued by corporations, the government or municipal entities, such as cities and states. They are vulnerable to two different types of risk: credit risk and interest rate risk.

Credit risk is the chance a bond issuer will go bankrupt and can’t pay. The greater the borrower’s risk of bankruptcy, the higher the bond’s yield and, generally speaking, the greater the volatility, too.

Companies with a low risk of default, for instance, issue investment-grade bonds rated triple-A to triple-B. The typical yield on investment-grade corporate debt in late April was 5.2%. High-yield bonds, also known as junk bonds, are issued by firms with lower credit ratings — double B to triple C — because they are deemed to have a higher risk of default; recently these IOUs offered better than 7% yields. But high-yield debt tends to trade more in line with stocks, unlike other types of bonds.

Bonds also have interest rate risk. When interest rates fall, bond prices rise and vice versa. For instance, in 2022, when interest rates rose at an unprecedented rate, the Bloomberg U.S. Aggregate Bond index plunged 13%.

Stocks: High volatility

All stocks are volatile, but some are more so than others. Shares in large companies with dependable earnings and dividends are generally lower risk than shares of small start-up companies, for instance.

Investment style can impact volatility, too. Growth funds, for instance, which invest in stocks of companies with above-average earnings growth, tend to be more volatile than value funds, which focus on unloved stocks trading at a discount. Core or blend funds are in the middle in terms of volatility because they hold a mix of growth and value shares.

International stocks have been a bit riskier than domestic stocks, in part because they carry currency risk. A strong dollar tends to dent returns in overseas stocks; a weak dollar, by contrast, tends to buoy foreign shares.

Sector funds invest in slices of the stock market, such as utilities, banks or technology. These funds can enhance portfolio returns, at times. But compared with broadly diversified stock funds, they can be more volatile, too.

HOW RISKY IS MY INVESTMENT?

Statisticians use several risk measures, most of which are widely available. Here are four. All are based on past data points — they’re backward-looking — but they are generally regarded as an indication of future behavior.

Standard deviation

The most commonly used definition of volatility is standard deviation, which depicts how much the return of an investment has varied from its long-term average over a certain period of time. The higher the standard deviation, the more volatile the security has been.

For example, SPDR S&P 500 (SPY), an exchange-traded fund that tracks the S&P 500 index, has a standard deviation of 16.1 over the past five years, which means that over that period, the ETF’s return has bounced up and down from its average return by 16.1 percentage points.

By contrast, Vanguard Total Bond ETF (BND) boasts a far lower five-year standard deviation of 6.3.

Beta

Beta measures the increase or decrease in price of an individual investment (stock or fund) compared with the market as a whole. A fund with a beta of less than one means its price rises and falls less dramatically than the broad market. A beta of greater than one means the security’s price tends to be more volatile than the market.

Alpha

This metric basically measures a fund’s ability to outperform (or underperform) an appropriate index. A fund with an alpha of 2.0 means it beat its benchmark by 2%; an alpha of negative 3.0 means it lagged the bogey by 3%. Ideally, a fund would have a low beta (less than one) and a high alpha (greater than zero).

Sharpe ratio

Devised by Nobel laureate William Sharpe, the Sharpe ratio is a risk-adjusted return. It measures how much excess return an investment has delivered relative to its volatility. (The actual calculation is a little more complex, but this is the general gist.)

The higher the Sharpe ratio, the greater the investment’s reward for the risks it has taken — in other words, the better the fund’s risk-adjusted performance.

Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.

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