3 Ways to Reduce the Effects of Stock Market Volatility

by KenFaulkenberry

in Portfolio Management

Stock Market Volatility

Stock Market Volatility

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?

Related Reading:

Portfolio Risk Control – Focus on What You Can Control


Written by KenFaulkenberry

KenFaulkenberry

AAAMP Blog by Ken Faulkenberry
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record.
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{ 4 comments }

Jarrett Gibbs

On October 13, 1989, all major networks flashed reports on the market decline. The ability of investors and the press to track stock prices on a virtually continuous basis has heightened public perceptions of a volatility problem. What we do not know, because the intraday data on stock prices are simply unavailable, is whether the large but extremely brief price drops that have characterized recent market declines also occurred in the past, when daily and monthly volatility was higher than it is today.

KenFaulkenberry

Excellent point Jarrett. Thank you.

Duncan Quinn

The Volatility Index (VIX) is the most popular measure of stock market volatility. A high reading on the VIX marks periods of higher stock market volatility. Low readings on the VIX mark periods of lower volatility. This index is important as it works easily with other market indicators. This indicator helps to ascertain when there is too much optimism or fear in the market. By analyzing its message, traders get better understanding of investor’s sentiments, and thus likely flip-flops in the market.

KenFaulkenberry

The VIX measures call and put option premiums in out of the money options. It is a good indicator of what investors perceive future volatility will be going forward. The problem is that is a short term indicator and has not been a good predictor of future volatility. What investors perceive as future risk often ends up being wrong, particularly at volatility extremes.

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