Instead of being a victim of stock market volatility a value investor can take advantage of it to increase investment returns. The value investor must be able to think the opposite, or contrary, to what others are thinking; particularly when there is a large majority or consensus on an investment.
Technology has increased the ability to trade assets worldwide and disseminate information and knowledge instantly. But what hasn’t changed is investor reactions and human emotions to the information received. The result is markets react stronger and quicker, creating large price swings; particularly in a stock market crash or secular bear market.
Stock Market Volatility Leads to Portfolio Volatility
Very few investors understand how stock market volatility eats away at your returns. If you haven’t read my post on portfolio volatility you may want to read it now. It’s an important investment concept. The simplest way I can explain it quickly is that if you have a 50% gain and a 50 % loss you have an average of 0% or break even. But you have actually lost 25% of your portfolio!
How to Reduce the Affects of Stock Market Volatility
1. Employ Fundamental Value Analysis
The kind of stock market volatility you really want to avoid is downside volatility. All major market tops coincide with high valuations. This makes fundamental value strategies an important part of investing. These tools can guide you away from over priced investments that are prevalent at market tops.
2. Have a Maximum Drawdown Plan
Have a maximum drawdown policy as a part of your risk management plan. A large part of your asset allocation strategy should be based on how you will manage and minimize a portfolio drawdown. It is large portfolio drawdowns that destroy your long term returns.
3. Use a Tactical Asset Allocation Strategy
A fixed or strategic asset allocation makes little sense because we know valuation is the biggest determinant of your long term investment returns. Once you are empowered with the knowledge from fundamental value analysis and have mapped out your risk management plan you can choose an appropriate asset allocation.
With a tactical asset allocation you have the flexibility to make allocation decisions that are based on maximizing your probability of positive outcomes. That means having ability to allocate more aggressively to under valued assets and avoid assets that do not provide a margin of safety.
Take Advantage of Stock Market Volatility
Benjamin Graham, considered by many to be the Father of Value Investing, used the parable of Mr. Market to illustrate the mindset the value investor should have towards stock market volatility. The market sets a price, the intelligent investor will know the fundamental value and sell when the price is too high, and buy when the price provides a low risk opportunity. Mr. Market demonstrates the proper mindset to take advantage of volatility.
Do you have the proper mindset to take advantage of stock market volatility?