Mitigating the effects of volatility and thoughts about China
It is early 2016, but already this year we have seen increased volatility rear its ugly head in global financial markets. After an extended period at below-average levels, volatility has escalated in recent months despite a stronger U.S. economy. Dysfunction in the Chinese markets, the Federal Reserve’s recent interest rate hike and challenges in emerging markets all are contributing to increased global market instability. At times like these, investors look to limit the impact of these factors on their portfolio. What, then, can be done to mitigate volatility’s effects? To help answer this question, I would like to discuss volatility in general and strategies to limit its impact and then follow up with some thoughts about why it is surprising that China’s markets are affecting volatility here.
First and foremost, it’s important to understand that volatility is not risk. Volatility is the movement of price in markets, whereas risk is the probability of actually losing money. The two concepts overlap when volatility forces investors to sell at a discounted price, thus locking in a loss.
One of the main reasons for investors to manage volatility through sound investment plans is to protect them from themselves. Emotional overreactions can lead to bad short-term investment decisions. In a perfect world, investments that exhibit no volatility, such as bank certificates of deposit or savings accounts, would produce ample returns to cover the negative impact of rising inflation. Unfortunately, that is not reality, so each investor must incorporate some risk into his or her long-term investment plans in order to experience higher returns to outpace inflation over time. Strategies to dampen volatility can reduce the probability of loss in a portfolio’s value and can, therefore, reduce risk.
Diversification is one fundamental investment tactic that helps. Investors should avoid putting all of their eggs in one basket and instead build a portfolio with a variety of non-correlated investments — such as emerging market small-cap stocks, large-cap U.S. stocks, different individual bonds and real estate investment trusts. Additionally, investors should remember to rebalance portfolio holdings as allocation weights change due to market movements.
One often overlooked method of dealing with volatility and managing portfolio risk is to match the time horizon for investments with the correct type of investment vehicle. A 5-year horizon requires a different investment choice than a 30-year horizon. Those retiring soon or paying college tuition in the near future, for example, should keep some funds in a money market account or in short-term bonds rather than in the stock market so that their reserve funds are not vulnerable to market volatility. At such times, some experts suggest having eight years’ worth of expenses in cash or short-term bond reserves.
Another way to curb the impact of volatility is to use market orders to establish investment limits. Trailing stop losses can be used to define an absolute downside minimum and buy limits can be set to establish when to buy investments. A knowledgeable financial adviser can help investors incorporate basic options strategies (such as buying protective puts and establishing collars) to reduce the impact of market volatility on investments.
In our current global financial environment — with chaotic Chinese stock markets manipulated by the government, historic lows in the energy sector, slowly rising U.S. interest rates and under-performing emerging markets — investors can mitigate risk by incorporating the above approaches to lessen the impact of volatility. But it is important to remember that market volatility is, by definition, temporary and market movements should be considered in their full context.
As previously mentioned, many analysts are blaming some of the volatility in our markets on turmoil in the Chinese markets. The two domestic Chinese stock exchanges, the Shanghai and Shenzhen, are notoriously volatile, so it is a bit confounding that U.S. investors are rattled by movements there. To allay investor concerns regarding China in particular, it is important to remember that while China has the world’s second-largest economy (with a 2014 nominal GDP equivalent to about $10 trillion), its economy is significantly smaller than that of the U.S. (with a 2014 nominal GDP of approximately $18 trillion). China’s economy is also good deal smaller than the EU economy in aggregate (with a 2014 aggregated nominal GDP equivalent to about $18.5 trillion). It would not be surprising, then, if the improvement in the U.S. economy more than offsets continued weakness in China.
Remember, a skilled financial adviser can help construct a portfolio with the worst-case situation in mind, giving investors peace of mind and freeing them from worry about the effects of market volatility on their investments.
Michael Joyce, founder and president of JoycePayne Partners of Bethlehem, Pa., and Richmond, is responsible for its overall investment strategy, management of investment portfolios and financial counseling services. He can be reached at [email protected].