- What will you do if volatility increases in 2018?
- Your behavior and risk appetite is more important than what will happen with stocks.
- We’ll discuss many strategies so you can find the one that will help you sleep well.
We are currently in an environment of extremely low volatility and extremely high complacency. The S&P 500 is up 20% year to date, the economy is doing well, and it all seems perfect.
No one knows if 2018 will be similar and therefore the only thing one can do is to have a plan of action prepared for any kind of scenario. Today, we’re going to discuss how to be prepared for an increase in volatility.
If you aren’t prepared, this article is for you.
The stock market’s volatility is measured by the VIX index which looks at the prices of short term options in order to give a measure of risk.
In the last year, the VIX index has been extremely low from an historical perspective as there haven’t been many shocks which has created the current complacency in markets.
The minor spikes in the above chart are related to silly issues—like North Korea this summer—that haven’t amounted to much. However, what is important to note is that the VIX index is fast to rise but declines slowly over a long period of time as past performance gives investors more confidence.
The VIX index has been slowly declining in the last 8 years with some spikes during the 2015 commodity downturn and fears related to China slowing down and a possible 2012 recession alongside U.S. budget issues. However, the VIX index rises extremely quickly. In 2008 for example, it quickly spiked from 15 to above 60 and that’s something every investor should be prepared for.
How To Prepare For Volatility
My point is that low volatility in combination with high stock prices in relation to fundamentals and being in the late part of the economic cycle is a risky situation to be in. From a scientific perspective, any increase in volatility will lead no negative developments with stocks.
The fact that stock prices fall when volatility rises isn’t news, but what is important is how will you behave when a spike in volatility happens. Given the low volatility and rising stock prices, most investors are complacent and a spike in volatility could easily catch them on the wrong foot.
Investors usually hold through the downturn only to sell in capitulation and buy back in when things turn back to optimism which leads to terrible long term returns. Where are you now on the above chart and how does your emotional state influence your investing activities? It’s extremely important to have a clear strategy in place for when we see an increase in volatility as this will prevent you from making emotional decisions.
A few options to give you some food for thought:
If you own put options or have sold call options and there is an increase in volatility, you will do well. On the contrary, if you sold put options or bought call options you might not be happy. However, the low volatility means that options are cheap and buying put options that would put a floor under your potential losses isn’t a bad idea now.
For just 5% percent of your portfolio, you can hedge it completely for 2018. As soon as volatility jumps up, the price of those options will also spike so if such protection is something for you, there isn’t a better time to do that than now. If the S&P 500 increases 15% in 2018, you will achieve a no risk 10% return.
Selling When Turmoil Comes
Timing the market is something nobody is really good at. You might be lucky once or twice, but doing it consistently is difficult. In the summer of 2015 and January of 2016, the S&P 500 had its last two significant corrections.
These two examples are perfect to test your behavior as since the 2016 lows, stocks are up 41%. Those who want confirmation from falling prices probably sold in January of 2016 only to buy back later while missing out on the initial upside.
You might think you would buy more if there is a correction, but what if the next correction is a real stock market crash and stocks fall more than 50%? As always, timing the market is nearly impossible and leads to more pain than gain in the long term.
Rebalancing Your Portfolio
Yesterday we discussed how bonds might not be such a bad investment anymore and definitely something to look at for those who want to be protected. Therefore, if you are sitting on large gains, you might want to swallow the tax cost and see what would help you sleep well. If you aren’t sleeping well, it means you are risking too much at this point in time.
The message for today and going into holiday festivities, apart from wishing you a great time with your loved ones, is to make you think about what your actions will be when things change.
I don’t know what your personal situation is, but I can give you a few links that may help you find what the best option is for you:
- We Could See Gold At $20,000. No, I’m Not Crazy.
- Don’t Underestimate Market Sentiment
- Now’s The Time To Consider These 7 Hedging Strategies
- This Is Why International Diversification Is So Important
- These 3 Tips Will Help You Survive The Next Market Crash
- There Are Big Global Risks Out There – Here’s How To Invest For Them
A new year is coming and it will be filled with opportunities and risks. Therefore, keep reading Investiv Daily for information on how to lower your risks and increase your long-term returns.