Embracing the Roller Coaster Ride: The Benefits of Market Volatility

The spring of 2020 brought a host of new stresses and concerns as the pandemic abruptly pushed normal life aside throughout our country.  For investors, those concerns included the significant drop in the stock market and wild market volatility during that time.  Fear about the economic impact of the pandemic led to daily swings of 5 to 10 percent in the stock market on multiple occasions in late March.  The Volatility Index (VIX) created by the Chicago Board Options Exchange, which measures price changes in the S&P 500 index, reached levels approaching—and, on March 16, 2020, even surpassing—the level of market volatility during the Great Recession.

While such levels of volatility are stressful to experience (and certainly a bit stressful to manage as investment advisers!), the stock market behaving like a roller coaster ride does present opportunities that can add significant value to investment portfolios.  Three ways to take advantage of market volatility are:  conducting trades to rebalance one’s portfolio, harvesting tax losses in a taxable account, and changing one’s monthly investments or withdrawals.

Rebalancing Trades.  If you have set targets for your portfolio and rebalance your accounts during periods of market volatility, you can increase the value of your investments while maintaining a tolerable amount of risk.  For example, consider an investor who had a $1 million portfolio in February 2020 and kept 70% of his portfolio in stocks and 30% in cash and bonds.  By late March, the value of his stock funds dropped by ~$250,000 while the value of his bond funds held steady.  As a result, the stock portion of his portfolio now represented only 60% of the total portfolio.  If he rebalanced to his target allocation (70% stocks / 30% cash and bonds) in late March, he would have used a portion of the cash and bonds to buy more stocks “on sale” while maintaining his desired level of risk.  In 2020, such a move would have paid off quickly, and by the spring of 2021, the investor’s portfolio would likely be worth over $1.15 million. 

Tax Loss Harvesting.  Another advantage of market volatility is that investors can harvest tax losses in a taxable account.  Consider an investor who purchased $100,000 in an S&P 500 Index fund in a taxable investment account in mid-February 2020.  By late March, the value of his investment had dropped to $70,000.  In that case, he could sell the current fund, buy a comparable S&P index fund as soon as possible thereafter, and realize a $30,000 capital loss for tax purposes while still benefiting from the rebound in the same segment of the stock market in which he initially invested.  For most investors, that $30,000 capital loss translates into $4,500 of federal tax savings, though it may have to be spread over a number of years given the annual limits on claiming capital losses.

There are several potential pitfalls in tax loss harvesting though.  For example, an investor should 1) ensure that she reinvests the proceeds of the sale in a similar investment while not triggering wash sale rules, 2) consider how tax loss harvesting trades could be offset by rebalancing trades in a retirement account instead (to further remove concerns of violating wash sale rules), 3) conduct the trades during the same business day if possible (or back-to-back days) to minimize the amount of price movement while her assets are out of the market (this is easier when realizing losses in stocks or ETFs that trade throughout the day, rather than mutual funds that only trade at market close), and 4) consider how best to use the tax asset resulting from the capital losses.

Changing Monthly Investments and Withdrawals.  Investors can also take advantage of market volatility by adjusting the allocation of their periodic investments—or withdrawals if they are taking regular distributions in retirement.  Imagine that an investor is still working and that she saves $2,000 per month to a taxable investment account.  Of that $2,000, she generally invests $1,500 in a stock fund and $500 in a bond fund.  When the market drops significantly, she can adjust her monthly investments so that all $2,000 is used for purchases of the stock fund while it is “on sale.” 

Conversely, a retired investor might sell $2,000 of investments per month to generate cash for his living expenses.  If he usually sells $1,500 of a stock fund and $500 of a bond fund each month but the stock market has just taken a nosedive, he could adjust his monthly sales to draw all $2,000 from the bond fund instead until the market recovers.

Each of these strategies demonstrate how—without trying to time or outguess the market—an investor can still be proactive in taking advantage of market volatility and thereby add value to their portfolio while maintaining an appropriate level of risk.  Above all though, it is most important in the face of market volatility to follow a steady course, not reacting emotionally to swings in the market but sticking to a target allocation for your portfolio that you hopefully set in place during a calmer time.  If any clients have questions about these strategies (or how we may have implemented them on your behalf), please call or email any time.