- The stock market has taken investors on a roller coaster ride and many investors are feeling queasy.
- Stock market volatility often leads to higher expected returns.
- To capture those higher returns, stock investors need to stay on track with portfolio rebalancing during market ups and downs.
I was a daredevil growing up. I took a lot of silly chances, discounting the potential ramifications if something went wrong. It’s rather funny, then, that I never liked roller coaster rides. In fact, they scared the bejesus out of me. Ask me to jump my home-made mini-bike over a 6-foot-wide ditch, and my answer would have likely been: Sure, why not? Take a ride on The American Eagle rollercoaster at Six Flags Great America? Fuhgeddaboudit.
I can’t say for certain why I dislike roller coaster rides. I am sure the stomach turns caused by the sudden drops has something to do with it. But I think what bothers me the most is not having control. If the roller coaster cart had a steering wheel, a gas pedal and a brake, I think I’d be good to go.
A roller coaster’s acceleration is measured in terms of gravitational force, or G-force, which refers to the sense of weight that is created by motion. By comparison, the stock market’s ups and downs are commonly measured in terms of the CBOE’s Volatility Index (often referred to by its ticker symbol VIX). More specifically, the VIX Index is a calculation of the expected future volatility of the U.S. stock market, derived from call and put options on the S&P 500 Index.
While I like a sense of control, thinking logically I understand that a roller coaster ride is much safer because it rides on a track, eliminating the need for a steering wheel, gas pedal or brakes. Similarly, while I enjoy steady, positive market returns, thinking logically I know that bouts of high volatility foster higher expected return. In turn, the higher short-term risk that volatility creates in equities provides the basis for investors in the stock market to demand higher returns than those generated by more stable assets, such as cash and short-term Treasuries.
The stock market has taken investors on quite the roller coaster ride of late. The VIX more than doubled over the past few months, rising from 12.05 in early October to as high as 36.07 on Christmas Eve. Recent swings in stock prices have pushed the VIX to a record of 13 one-day swings of more than 20 percent this year. When the VIX rises, it is an indication that stock options traders are betting that the fluctuation in stock prices will increase in the short term. Many equity investors also regard an elevated VIX as a warning sign that a market correction – or perhaps even a secular bear market – is looming.
The recent surge in market volatility looks worrisome, but as Newton’s third law reminds us: For every action, there is an equal and opposite reaction. No less is true for financial markets and so a sharp drop in prices coincides with a sharp rise in expected future return. Buying low, in other words, lays the groundwork for selling high.
“Rebalancing” refers to periodically realigning an investment portfolio to keep the amount invested in different sectors of the market consistent with their target allocations. Rebalancing is accomplished by adding to positions in a portfolio that have fallen in price (i.e. buying low) and reducing positions that have risen (selling high).
Rebalancing is a powerful tool for turning market volatility into market opportunity. Systematic rebalancing is at the heart of The Milwaukee Company’s rules-based investment strategies for just that reason. By systematically shifting asset allocations back to target weights, we’re raising the odds that client portfolios will stay on track when market volatility comes along.
Rebalancing, then, offers investors a path to participate in the higher future returns that typically follow bear markets, but this isn’t a free lunch. As Warren Buffet is fond of saying: “Successful investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant”.
Roller coaster riders expect to get tossed around violently, but they still pay to experience the G-force that the ride creates, because they are confident that the ride will end safely. Similarly, long-term investors shouldn’t abandon their commitment to the stock market during bouts of high volatility because it’s safe to assume that stocks will generate higher returns than more stable investments over the long term.
Keep this in mind and you will be able to tolerate stock market volatility just as well as Mr. Bean tolerated his first roller coaster ride.
The Market Commentator