Growing up in Southern California I went to Disneyland often. In the ‘70s they issued tickets rather than an all-inclusive pass. Their ticket system used letters – A through E, with an E Ticket being the most coveted. They were the most popular and exciting rides like the Matterhorn or Space Mountain. The ticket book consisted mostly of A tickets with a couple of E tickets. My friends and I would scour the park looking for E Tickets if we ran out of money to buy more. At the end of the night, I’d go home with several A tickets stuffed into the front pocket of my Toughskin jeans
The Matterhorn and Space Mountain were a blast to ride. Rising, falling, and twisting at high speeds is a thrill – but not for everybody. Slow, steady climbs followed by steep and rapid drops aren’t for the faint of heart.
The stock market is like a roller coaster. It’s a slow steady climb punctuated by a few steep and rapid declines. Last year is a perfect example. From January 1 to October 3 the Dow Jones rose 8.5%. From October 3 to December 24 it fell 18.7%.
The VIX is the volatility, or risk, index and it spiked 210% as the market fell during the fourth quarter of last year. The VIX is currently trading around 16. At 16, it projects a 1% daily move in the stock market. With the Dow currently trading at 26,000 a 1% move means the market can rise or fall 260 points daily.
To calculate how much an index, or stock, can move divide the implied volatility by the square root of 256. What is the square root of 256? It’s 16. Why 256? There are approximately 256 trading days during a calendar year. The current implied volatility of the VIX is 16, 16 divided by the square root of 256 is 1. If implied volatility spikes to 32, then the daily move in the market would be 2%, or 520 points – up or down.
The implied volatility of Apple is about 28, meaning a daily move of 1.75% (28/16). Apple is currently trading for $189, so a 1.75% move is $3.30 – up or down.
Volatility returned to the market in May. From January through April the Dow Jones rose 14% with barely a ripple. In May it fell 6.1% while volatility leaped 26.4%.
Risk, volatility and wealth are intertwined. The stock market carries risk, and therefore you can earn an equity premium, and this is where wealth is created. Since 1926 stocks have risen around 75% of the time, averaging 10%. U.S. T-Bills are safe and have never lost money, however, after taxes and inflation are factored into your returns, they become negative.
How should you handle volatility?
Buy the dip. Stocks rise and fall. When they drop, use it as an opportunity to buy quality stocks or index funds. If you had the courage to buy stocks on Christmas Eve, you would’ve made 19% on your investment. During the Christmas Eve rout stocks fell 6.3% or about 1,400 points, so buying stocks would’ve required fortitude and grit.
Keep a shopping list. Identify stocks or funds you want to purchase at lower prices and when the market falls it will give you an opportunity to buy some shares. For example, the price of Apple dropped to $146 in December. It’s now trading at $190 – a gain of 30%.
Automate. Automate your investments to remove emotion from the buying process. Set up a monthly draft from your bank to your investment account and you’ll be able to dollar cost average into the stock market regardless if it’s up, down or sideways. Investing $100 per month for the past 20 years in the Vanguard S&P 500 index fund is now worth $64,266 – an average annual return of 8.13% per year.
Buy bonds. If you’re concerned about volatility in the stock market, buy bonds. U.S. Government bonds are a great hedge for falling stocks. As stocks fell in May, long-term U.S. Government bonds rose 6.4%. During the market meltdown in 2008 government bonds rose 28%.
Do nothing. Volatility is like turbulence; it will eventually pass. When an airplane hits a turbulent patch, the pilot reminds us to stay seated and tighten our seatbelt. The pilot knows it will be temporary. Flying is a few moments of fear mixed in with hours of boredom. May is gone and the first week of June is looking good for stocks. In fact, it’s the best weekly performance of the year.
Don’t panic. Investors without a plan sell stocks when the market falls and buy when it rises. When the market isn’t cooperating – sit tight. In December investors withdrew $183 billion from mutual funds as the market fell. When the market rebounded in January and February, they added $43 billion. If you sell when the market is falling, you’ll miss the rebound and the opportunity to generate meaningful long-term gains.
Volatility is part of investing. It is a tool you can use to enhance your returns, if you use it correctly.
Stay in your seat come times of trouble. Its only people who jump off the roller coaster who get hurt. ~ Paul Harvey
June 7, 2019
Bill Parrott, CFP®, CKA® is the President and CEO of Parrott Wealth Management located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose.
Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation.