How to make market volatility your friend

Maintaining positions in a well-diversified portfolio is the best response to market volatility. But there may be something else investors can do: Use falling prices as an investment opportunity. As this article argues, market declines aren’t purely negative events. They can allow investors to buy stocks that would have been more expensive a month or a year previously. A sidebar discusses why, when evaluating portfolio risk, the investor’s time horizon is critical.

How to make market volatility your friend

Recent market gyrations have made even strong-stomached investors a little queasy. In general, maintaining your positions in a well-diversified portfolio is the best response to such volatility. But there may be something else you can do: Use falling prices as an investment opportunity.

Think long term

Although overall stock prices have historically risen over time, the long-term upward trend has been interrupted many times by shorter-term drops. This combination of a generally rising market and short-term volatility is what makes stocks well suited for many long-term investing goals but not advisable for imminent financial needs.

If your portfolio is already broadly diversified and you’re investing for long-term goals as part of a larger financial plan, you can probably ignore day-to-day market fluctuations. That’s because a good investment strategy will apply regardless of market conditions. Indeed, paying too much attention to daily swings in stock values can be a recipe for making emotional investment decisions that may actually move you further away from your goals. For example, you may sell a depressed stock at a loss only to watch it subsequently run up — without you.

Cushion blows

Diversification and asset allocation are especially critical when market conditions are declining. When your money is spread across multiple asset classes with performance that isn’t tightly correlated, you reduce the potential negative impact any one sector or security has on your portfolio. In other words, when your stocks are performing poorly, your fixed-income, cash or alternative investments may be performing better and thus cushion the blow of stock losses.

That’s the ideal, of course, not a guarantee. Sometimes, even historically uncorrelated asset classes can move in tandem. Following 2008’s infamous financial meltdown, for example, many types of investments experienced significant losses — including traditional portfolio diversifiers such as real estate investment trusts (REITs).

Regularly rebalancing your portfolio so that your investments match your target asset allocation (for example, 50% stocks, 45% bonds and 5% cash) can also help protect you from market volatility. If you neglect to rebalance your portfolio, you may get too much exposure to securities that have run up and, therefore, are currently overpriced. Such investments may be more vulnerable to a price correction in the event of a market downturn.

Check the price

Market declines aren’t purely negative events. They can provide opportunities to invest in stocks that would have been more expensive a month or a year previously. Taking advantage of such buying opportunities may position you for better future performance — sometimes dramatically so.

This isn’t to say that you’ll be able to figure out exactly the right time to buy in. Not even investing professionals can reliably time the markets. Also, some stocks that have declined will continue to do so. That’s why it’s important to thoroughly research any potential investments to learn whether company-specific factors are to blame for recent declines.

However, the fact remains that purchase price matters when it comes to investment returns. It’s better to buy a good company when its stock is cheap than when its stock is expensive. Volatility can provide you with the opportunity to do that.

Take tax losses

Volatility can also provide tax benefits. If falling markets cause some of your holdings to lose value, you may decide to sell them to realize losses that can be applied against future capital gains.

This is a particularly useful strategy if you have investments that you were thinking of selling anyway. Remember that you can always buy stock shares back after 30 full days have passed since you sold them and recognize the tax loss — an IRS requirement known as the “wash sale” rule. But before you sell, you should discuss your plans with your tax advisor.

Consider selling

Talk to your financial advisor about whether your portfolio has the right amount of diversification given your personal situation and goals. And as the year end approaches, consider selling some securities to recognize tax losses and free up funds to make new investments.

Sidebar: Time affects investment risk

When evaluating investment portfolio risk, your time horizon is critical. Time horizon simply means the length of time you plan to hold an investment before you liquidate it. Many academic studies have shown that the longer your time horizon, the greater your ability to withstand short-term price volatility and the more likely you are to enjoy healthy, positive returns.

If you’re investing for retirement, for example, and your time horizon is 10, 20 or 30 years, then the risk associated with a well-diversified portfolio is relatively low. This is true even if your portfolio is weighted toward higher-risk assets, such as stocks. If, on the other hand, your time horizon is short — perhaps you’re saving to buy a home or pay a child’s college tuition in two or three years — even a well-diversified portfolio will carry higher risk.

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