On Friday, February 2nd The Dow closed down 666 points, or 2.5%. The sudden move came unexpectedly as inflation data came in slightly higher than expected. The following week the Dow continued its decline, at one point down 10% from the highs. While we could explore the cause of this particular decline, it is just as important to understand the best way that you as an investor can respond to market volatility.
When the market fluctuates, the human response is to act: ”Should I buy more or should I sell?” Fear and panic during downturns in the market drive people to act rashly, rather than taking the time to understand the situation and then act.
Volatility is a term frequently thrown around to describe movements in the market. Just as often, you will hear financial pundits referencing an increase in the VIX or volatility index. While we may understand what market volatility means in context, many would be hard pressed to explain what the VIX is actually measuring. Yet, as volatility increases, people tend to panic and act based on it. In reality, buying or selling based on market turbulence could ultimately set you behind in the long run through lower returns, trading fees, and tax implications.
The VIX or volatility index rises when investors expect larger swings in the market. The expectation is reflected through higher premiums paid for options. When investors are willing to pay a higher premium, it indicates a greater expectation of volatility, and is then reflected through an increase in the VIX. It is important to understand that while volatility is typically used in a negative context, it does not necessarily imply a downward movement in the market.
In a few words, an increase in the VIX represents an increase in uncertainty. When the market goes down, uncertainty understandably rises. In this context, it becomes clearer that decisions regarding the purchase or sale of assets can be more difficult to make. The best course of action is to understand the cause of the uncertainty and then use this knowledge to make an informed decision.
While it can be difficult to overcome the gut reaction to act quickly to protect your money, taking the time to understand what is going on in the market is vitally important to make the correct decision. Rarely can anyone buy right at the bottom or sell at the top; people are often caught right in-between. Warren Buffet famously said investors should be “fearful when others are greedy and greedy when others are fearful.” Moving your money in reaction to market turmoil is the antithesis to these wise words. When buying and selling is as easy as the click of a button, it is all too easy to react impulsively. Next time panic engulfs the market, remember to take a step back and understand the factors influencing the downturn and then make your informed decision.
One other thing to be aware of is that as market volatility has settled down a bit and markets have recovered from the lows, it is a good time to assess your current portfolio. How nervous, if at all, did the recent drop make you? If the drop was the beginning of a deeper correction, are you well positioned. The only right answer is the one for you and your family, but now is a good time to consult with your financial advisor and/or financial plan and decide on a course of action.
For more information on investment strategies, read our article, Market Bubbles Are Inevitable; Portfolio Bubbles Are Not.