Savvy investors understand that market volatility is a normal part of the economic cycle. Market volatility involves both upward and downward movement, but when we use the term 'volatility' we are most often referring to downside exposure. When considering downside volatility it's important to distinguish pullbacks from corrections, and to know how your investment approach will navigate them.
Market Pullbacks of 5-10% are common, and it is not unusual to see multiple pullbacks within a 12 month period. We consider these 'recalibrations' and they typically occur when the market is overbought or after the release of news that affects fundamentals. Managers typically welcome pullbacks because they often reset valuations and present new buying opportunities.
Market Corrections of 10-15% are also normal, and while not as prominent as Market Pullbacks, should be viewed in a similar light, but with more caution. It is important to keep corrections in proper perspective. Since 2000, the S&P 500 has gained, on average, more than 8% the month following the bottom of a market correction, then gain around 24% the following year. So, not only have corrections been short-lived, but they have also been followed by significant market gains.
Different investment management approaches work through volatility differently. Core strategies tend to use pullbacks to improve portfolio quality, but often only make minor changes to the overall allocation during market corrections. In contrast, tactical strategies that focus on enhancing returns or limiting loss are expected to make significant changes during market corrections. In fact, it is during market corrections that tactical strategies are expected to prove their worth by either reducing downside exposure to exploiting opportunities to enhance upside potential. Strategies that employ alternative investments will often come into play during extending economic contractions (recessions).
Changes to an investment strategy during volatile markets carries the risk of getting 'whipsawed'. Whipsaw can occur when the value of investments sharply change expectantly after being bought or sold. Downside whipsaw results when an investment rebounds sharply after being sold. Upside whipsaw occurs when an investment sharply decreases after being bought. Between the two, downside whipsaw carries unlimited upside risk whereas upside whipsaw is technically limited to the value of your investment. In general, the risk of whipsaw is minimized in core strategies that rely upon a strategic buy and hold approach. Tactical strategies, however, can amplify the risk of whipsaw while attempting to limit losses (downside whipsaw risk) or enhance returns (upside whipsaw risk).
Should I Get More Conservative During A Correction?
If you feel your risk tolerance has changed then it is important to realign your approach. The question is when to do so? Becoming more conservative during a market correction generally locks in losses, limits upside potential, and creates exposure to downside whipsaw. If an investor believes the markets will recover then it's prudent to wait till the markets rebound before changing strategies. If, however, an investor is convinced there is no foreseeable 'upside' to the markets then the only real concern is avoiding further downside exposure. If an investor adopts such a 'doomsday' narrative then their investment approach should probably shift towards limit loss strategies and alternative investments that replace traditional stock and bond positions. Bottom line... the markets have always recovered and those who choose to become more conservative during corrections have locked in expensive losses that patient investors have avoided.
While it's often costly to change strategies mid stream, please reach out to discuss your options if you feeling especially nervous about current market volatility. Even if immediate change isn't warranted, it is crucial to confirm whether eventual changes are.
Investors cannot directly invest in indices. Past performance does not guarantee future results.
Investments in securities do not offer a fix rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and, when sold or redeemed, you may receive more or less than originally invested. No system or financial planning strategy can guarantee future results.