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Portfolio > ETFs > Broad Market

How to Take Advantage of Stock Market Volatility

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The COVID-19 pandemic has made lockdowns, quarantines and “social distancing” the norm in much of the world. Violent moves in the market have become commonplace, a natural response to uncertainty about the spread of the virus and resultant impact on economic growth.

Although it is understandable to think of market volatility as an unusual occurrence, meaningful downturns in the market are common. Since 1980, the S&P 500 has experienced at least an intra-year drop of 10% in 23 years and a 15% or greater drop in 15 years. Despite frequent intra-year downturns, calendar year returns for the S&P 500 were positive in 30 of the past 40 years. Unfortunately, the magnitude of this year’s equity selloff makes a recovery to positive territory seem unlikely in 2020.

The temptation to time the markets is hard to avoid, but market timing is usually a recipe for failure. Morningstar’s annual study of 20-year returns illustrates the perils of market timing. Investors in the U.S. equity market for the full 20-year period through the end of 2019 earned 6.1% per year, while investors who missed the 10 best days saw their returns drop to 2.4% per year. Although avoiding the 10 worst days would boost returns, the best and worst days tend to be clustered together. Unfortunately, there are few (if any) investors able to trade with the perfect foresight to capture the upside and avoid the downside.

Calling the bottom in the COVID-19 crisis will be extremely difficult. Investors will be looking for a slowdown in the number of new Covid-19 cases, progress in the ability to treat victims of the outbreak, and early indications that people can resume normal living. Government policy to prevent near-term liquidity issues from becoming long-lasting solvency issues will also have an important influence on investor sentiment. With uncertainty remaining at extreme levels, it seems foolish to make any bold declarations about the near-term direction for equity prices.

However, market dislocations can often provide company-level buying opportunities; there is a profound difference between making incremental portfolio changes in response to market volatility and “all-in/all-out” strategies to try to call market tops or bottoms. Benjamin Graham, the “father of value investing,” stated, “The day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment.” Emotional swings are often disconnected from fundamentals, creating divergences between price and intrinsic value. Investors with a well-informed point of view can take advantage of panic-driven situations to buy stocks that are temporarily undervalued or sell stocks that are temporarily overvalued.

Investors trying to take advantage of market volatility should follow a systematic framework for reviewing the investment opportunity:

  1. Determine whether there are heightened risks (or opportunities) created by the market environment.
  2. Evaluate whether the company’s business model and financial structure is equipped to succeed during the period of market or economic instability. There are often companies with compelling business models that lack the capital to survive an extended downturn.
  3. Test that the assumptions made about the intrinsic value of the company haven’t changed. Changes in interest rates, economic behavior or consumer preferences are among the considerations that can validate or invalidate the investment opportunity.
  4. “Look before you leap” by examining contrary opinions about the company. Seeking contrary viewpoints is a good way to identify shortcomings in the investment analysis.
  5. Define “success” and “failure.”  Establishing criteria to define whether an investment is working as expected or is falling short of expectations can make it easier to be disciplined about cutting losses more rapidly on losing investments.

In times like these, it is important to remember that the permanent loss of capital associated with making bad investments or selling at inopportune times is far more damaging than short-term spikes in market volatility. Most causes of permanent loss of capital are self-inflicted.  Failing to maintain enough liquidity to meet unexpected expenses increases the likelihood of having to sell assets at inopportune times. Being overly leveraged also raises the vulnerability of being a forced seller, the unfortunate fate of too many real estate investors in 2008 and 2009.  Panic is perhaps the most common trigger of permanent loss of capital and provides another argument in favor of maintaining a moderate intake of financial news.

Investors with well-diversified and liquid portfolios are better positioned to weather the storm when market volatility picks up. Successful investors such as Warren Buffett embrace the positive aspects of market volatility, with market dislocations providing periodic opportunities to invest in good companies at “discounted” prices.

Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.

Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.

Daniel is a graduate of Brandeis University and earned his MBA in Finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.


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