Being in a pandemic for the last six months or so has created considerable concern about what the market will do. Market volatility, risk tolerance, and asset allocation are terms being thrown around that frequently are not understood or are misunderstood by individuals.
Market volatility is the movement of stock prices up and down – it is the movement, not the direction, that determines volatility. Stocks regularly go up and down in a day, which is volatility. When speaking of market volatility, the word is often used when there is a higher degree of movement.
If there were no movement in a stock price, there would be no opportunity to profit. No movement would mean the stock price stays constant and there is no profit would be made. It is the volatility that creates the opportunity. If that volatility is a downward movement, the stock price is decreasing. Is the stock still worthwhile? Has anything changed with the business that makes the stock less valuable? Volatility driving a stock price downward is providing you the opportunity to purchase that stock on sale.
For example, GAH stock’s price today is $125 p year. Nothing has changed with the company, but because of general concerns, the share price for GAH drops to $100 per share. It is like the stock is being discounted 20% and you get to purchase at that discounted price. You purchase 100 shares at $100 per share for a total cost of $10,000. The general stock market recovers from its downward volatility and the GAH share price returns to $125 per share. Your 100 shares are now valued at $12,500. You have a profit of $2,500.
Some events or situations cause larger market volatility swings, most often coming back to uncertainty. The current pandemic has a lot of uncertainty – how will workers fair and what will unemployment do, how will the economy react, what will be the sustainability of many businesses that have been closed for weeks or months, etc. That uncertainty causes volatility.
We often see volatility during presidential election years. Our democratic system, with its two major parties, means that less than half of the voting population will not be happy. What are the concerns regarding the economy based on who is elected? Will there be changes in government spending? Will there be income tax changes? The what-if questions create uncertainty, which creates market volatility.
Significant changes to oil and gasoline prices. Major weather disturbances like hurricanes or floods. Natural disasters like the current wildfires. Global political crises. There are so many more examples that can create uncertainty, fear, or concern, leading to market volatility.
How does one manage market volatility? This is where risk tolerance and asset allocation need to be considered. If you pay attention to these characteristics, your best course of action may be to do nothing during market volatility.
Risk tolerance is the degree of risk that you are comfortable in taking, the amount of uncertainty that you can handle. We often hear about the “gut check” – can I still sleep at night if my account value drops 50%, 25%, 10%, or 5%? Again, no one wants their account value to do go down. If the anticipation is that the decrease is temporary, it becomes that buying opportunity. Risk tolerance helps you determine how to divide your investments, how to asset allocate your investments to have the degree of risk you are willing to accept.
The different types of investments – large company or small company stocks, well-established countries where the business exists versus more emerging or volatile countries, particular sectors, all play into how much risk you are taking. Think about a big company like Proctor & Gamble or Microsoft with lots of different products. While there are no guarantees, the thought is there is less chance of that more established company going bankrupt than your small, start-up company. If you want a lower degree of risk, you will more likely purchase the more established company or even look more into fixed income than stocks.
There are different categories of stocks – large, medium, small, and even micro stocks. There are international (outside the United States) versus domestic (within the US) versus global (both international and domestic). Add this to non-stock investments like bonds, real estate, and other alternative investments. Owning many of these different investments creates a risk score for you. Investors should often have some funds in each category – the percentages allocated to each will change depending on your risk tolerance.
Factors such as your age and financial situation often come into play in determining your risk tolerance. A 20-year-old with 30 or 40 years to recover from downward market volatility generally should be willing to accept more risk than a 70-year-old who is dependent on the funds to pay current living expenses. Even the 70-year-old may need to accept some degree of risk to keep up with inflation and taxes.
Once you have determined how much risk you are willing to accept, what your risk tolerance is, it can lead you to your asset allocation. What percentage do you want in fixed income, which has less volatility? What percentage of your investments do you want in large-company stocks versus med-company versus the small company stocks? Do you want only to look at more established countries in Europe or Asia versus the emerging, more volatile countries in Africa or South America?
We believe that investors need portions of their portfolios in all the different categories. What changes is the percentage in each category depending on your risk tolerance.
Market volatility is one source of risk and needs to be considered when looking at your risk tolerance. You must consider other sources of risk. Consider purchasing power risk – are your investments outpacing the rate of inflation long-term. If not, your standard of living may need to change because you will not be able to afford the same products and services when the price doubles due to inflation in the next 20 to 30 years. Keeping up with increasing taxes needs to factor into your willingness to accept risk. Currency risk comes into play if you are investing internationally or globally.
There are very few individuals who like to see the value of their portfolio decrease. Focusing only on market volatility and not doing that “gut check” for other types of risk can negatively impact your financial future. Individuals may see the value of their portfolio going down as an opportunity. They purchase stocks at what may be discounted prices. They do Roth conversions or tax harvest to reduce income tax risk. Planning with Purpose is here to help you do that “gut check”, to help you sleep at night, knowing you are considering the different areas of risk and managing for them all. We want to manage those risks and help you manage your emotions around market volatility and risk.