Market volatility is back! Maybe some day traders are rejoicing, but for most of the population, it can feel like a cause for concern.
Before you decide to make some yolo trades or liquidate your portfolio and quit, read this article first.
What is volatility?
A simple way to understand market volatility is to see how much a stock’s price fluctuates. If you see the chart for ITOT (which tracks to the S&P1500 index), you can clearly see the big ups and downs in price over the past few months. High volatility environments lead to large up- and downswings over fairly short periods of time (there is a more comprehensive definition here from Investopedia in case you’re interested). Put another way, high volatility is like Detroit’s weather (snow storm one day, sunny and warm the next day). Low volatility is like the weather in Los Angeles (sunny and warm basically year-round).
What causes volatility?
There are plenty of great academic papers detailing the different models and factors that contribute to volatility, which in turn affect asset prices. For simplicity’s sake, we can think of it in terms of the market’s sense of uncertainty. The greater the sense of uncertainty, the greater the volatility. Because equity prices are forward-looking, current prices reflect the market’s best understanding of what will happen in the future.
Taking the above example of ITOT over the past few months, we can clearly see huge variance in stock price. While a few percentage points up or down may not seem like a lot, this chart represents the entire US market. Investors have been primarily concerned over two issues: Fed interest rate hikes and US-China trade war.
First, the Fed has been inconsistent in its commentary on rate hikes in 2019. Future interest rates play a big part in the market. With a higher future interest:
Bonds become more attractive vs. equities
Corporate debt becomes more expensive, and discourages companies from using too much leverage
Loans generally become more expensive (especially for those that have floating rate loans, whether for student loans, car loans or mortgages)
In short, raising interest rates reduces both consumer and corporate spending, which generally slows the economy. Then why does the Fed raise rates in the first place? Because there is a need to keep inflation in check. If inflation starts to grow out of control, prices can grow at an unsustainable pace. With serious inflation, your morning Starbucks might jump from $4/cup to $6/cup in just a year. (And people would still buy it each morning anyway. Sigh.)
Second, there continues to be confusion regarding the state of affairs between the US and China regarding tariffs and trade. Months ago, Trump proposed tariffs on Chinese goods in retaliation to China’s refusal to change its policy on taking intellectual property and technology as a means of entry. The two sides have traded tariffs, and continued to escalate when the other has refused to back down. Little bits of news have significantly impacted the market as investors wait with bated breath for any signs of a resolution to the conflict.
Both issues have a major impact on the 2019 economic outlook. Unfortunately, both issues also remain very unclear. No one is entirely sure what to expect, contributing to the sustained volatility over the past two months in particular.
So what should I do in this volatile market environment?
Truthfully, it’s probably best to simply stay the course. As I’ve already mentioned in this article about the golden principles of investing, know your timeline. If you need a large amount of cash soon, it’s best not to invest any additional funds. Do not place all of your eggs in one stock - stick with ETFs. Buy low and hold. Do not try to “flip” investments for short-term profit unless you are committed to becoming a trader. It requires an appropriate amount of research, practice, and diligence to succeed this way.
There’s just one thing I would change given a volatile environment - an extra focus on dollar cost averaging. Because prices continue to fluctuate significantly, I have been more intentional in buying a bit more aggressively on the dips. I have a long term timeline, and the total market tends to double every seven years.
For those who end up feeling very anxious looking at the prices of equities swing up and down dramatically, it’s important to exercise extra self-control. It will always be tempting to follow the crowd (panic selling, panic buying), but this is often what results in the greatest losses. Riding roller coasters is meant to be fun. If you’re vomiting instead of having fun, maybe you should reconsider jumping on the next ride. If you don’t trust yourself, then keep dollar cost averaging on a flat schedule (rather than buying more or less in response to market movements).
As a final note, remind yourself to stay grounded. The type of investing I am promoting is a long-term, passive strategy that is meant to provide a person greater financial freedom or flexibility in the future. If you find yourself becoming enslaved to the market (constantly checking prices, making rash decisions with trades, or otherwise having your thoughts consumed by the market), then it may be best to take a step back. You cannot serve both God and money. Keep your priorities straight, regardless of what the market is doing.
Good luck and invest wisely.