Financial advisors always warn inexperienced investors of the possibility of stock market volatility, yet when the going gets rough, some react irrationally and begin selling when they should not. Experienced investors use such tools as the Volatility Index (VIX) to better understand risk and follow strategies designed to lessen the effects of volatility on their investment portfolio.
ABCs of the VIX
When the stock market begins to turn, a hot topic of conversation in the financial media is the VIX. The VIX was introduced in 1993 by the Chicago Board Options Exchange (CBOE). According to the CBOE, the VIX “is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.” It is often referred to as the “investor fear gauge.”
VIX readings below 20 generally indicate a relatively complacent mood among investors, while levels above 30 are associated with heightened fear. In October 2008, soon after the collapse of investment bank Lehman Brothers, the VIX soared to around 80. Although the VIX was not in existence on Black Monday (October 19, 1987), when the U.S. stock market plunged more than 20% in a single day, the CBOE later calculated that volatility spiked to an all-time high of 172.79 on the following day.
Ideally, the VIX would provide advance notice of stock market peaks and troughs, but perhaps the most you can gather from the VIX is a general sense of investors’ level of anxiety at any given time.
Strategies to Consider
Despite the VIX’s limitations as a predictive tool, you can take steps to help protect your investment portfolio against volatility. Begin by acknowledging that periodic bouts of extreme volatility will occur. Your advisor will likely suggest that you diversify your portfolio. Diversification cannot prevent losses or guarantee profits. However, spreading your equity investments among various sectors of the market and allocating a portion of your portfolio to fixed income, cash and possibly other asset classes can potentially help mitigate losses when the stock market heads south. Remember, the best time to think about greater diversification is before the market plunges. In addition, how you should react to significant market declines will depend on your risk tolerance, investment time horizon and financial goals.
Try to avoid market timing. Investors who attempt to time the market may end up boosting their allocations to stocks ahead of market downturns and lightening up near important bottoms — just the opposite of what would be ideal.
Finally, consider dollar-cost averaging. Many people do this when investing in a 401(k) plan. That is, you invest a set dollar amount every week, month or quarter, regardless of how the market is doing. Consequently, you end up buying more shares when prices are low and fewer when prices are high. Again, profits are not guaranteed, and you need to consider your ability to continue to invest amid declining prices. But this method gives you a disciplined, steady way to help build your portfolio.
Ride the Roller Coaster
Risk and volatility are major parts of making investments. Investing in the market, specifically, can feel like a nonstop roller coaster ride. The good news is that you can take steps to help ease the extreme ups and downs. For help assessing your situation and implementing the best strategies designed to tame volatility, contact Renee Andrews-Tushinski at 312.670.7444.
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