How to Prepare for Volatile Markets

Volatility

The last few years have been a relatively calm period for the US stock market, with few of the large swings that characterized markets during the financial crisis and the subsequent few years. But if the start of this year is any indication, 2016 may be more turbulent. What should you do with your investments to protect yourself from that possibility?

The answer might actually be “nothing.” The first few days of a year don’t necessarily predict how the rest of the year will turn out. And larger market moves don’t necessarily mean you should make any changes to your portfolio. Markets go up and down all the time, and taking no risk with your investments would mean you wouldn’t have the chance to achieve more than meager returns. But if you are worried about market volatility there are a number of ways to try to combat it, some more advisable than others.

One way to try to protect yourself is to directly bet on volatility so that you’ll profit if markets become more tumultuous. These types of bets typically involve complex financial products such as options or exchange-traded products based on an index of stock market volatility. While betting on volatility can work in the short term if you guess correctly, it’s generally a terrible long-term strategy. For example, the iPath S&P 500 VIX Short-Term Futures ETN, one of the exchange-traded products tied to volatility, has lost more than 99% of its value since early 2009. Unless you fully understand how these types of products work and the unique risks involved, betting directly on volatility probably isn’t a good idea.

A second way to try to counteract stormy markets is to shift some of your stock allocation into “low-volatility” funds. These investment products have proliferated in recent years and hold stocks that historically have had been less volatile. These funds can indeed help reduce the impact of choppy markets, but there’s no guarantee that the stocks that historically bounced around less will outperform during any one future period of stock market instability. It’s also worth considering that some of these funds may shift your exposure not just toward less-volatile individual stocks, but also more broadly to less-volatile market sectors (such as utilities). Changing your sector exposure isn’t necessarily good or bad, but it’s something to be aware of if you’re thinking about low-volatility funds.

Perhaps the simplest way to prepare for market turbulence is simply to shift some of your allocation in higher-risk investments (such as stocks) into lower-risk investments (such as bonds). Shifting your allocation doesn’t mean completely abandoning stocks—you don’t want to make it impossible to achieve your financial goals if stocks actually perform well—but rather making slight adjustments so that you’re more comfortable with how your portfolio is positioned. After all, if the possibility of more volatile markets is keeping you awake at night, that may be a sign that your portfolio isn’t properly calibrated to your risk tolerance.