Economic growth in the United States, and positive company earnings, continues to drive the stock market to record highs even though we are facing geopolitical risks in the Middle East and Ukraine, and weak growth in the European Union. These risks are being largely ignored. Low volatility levels, as measured by the CBOE Volatility Index, have remained below historical norms for most of 2013 and 2014. During this time, markets have avoided “normal” stock market corrections. According to research published by Capital Research and Management Group, a -5% correction will usually occur three times a year and a -10% correction will occur once a year. Larger corrections of -15% and -20% occur periodically every two, and three and half, years, respectively.
An investor lulled to comfort by low volatility may place their portfolio at greater risk. Becoming complacent and/or not truly understanding the volatility of an asset class or security can have negative impacts on a portfolio. Investors who lose fear, or fail to recognize the true volatility, may harm their portfolio by over-allocating to securities, expecting high returns with an assumption that the risk level will remain lower. Psychologically, the investor has marginalized the inherent risk of the stock market and its historical behavior. Unfortunately, these investors will eventually realize that their portfolio inaccurately judged the risk when volatility returns, causing the investor to experience unintended losses and stress from falling market values created by a negative market environment.
Historical data indicates that volatility will reappear in the future. So how can you prepare for the return of volatility? Investors can take some simple steps to prepare for the future. First, reassess risk tolerance. If you were 60 years old when the most recent bull market began, you are now 65. Is the level of risk in your portfolio appropriate today? Second, rebalance portfolio exposure. Periodic rebalancing is an important exercise to remove unintended allocation exposures that arise from market gains. Third, diversify the portfolio. A properly-diversified portfolio should result in a smoother ride and lower volatility due to various interactions of asset classes during different market cycles.
So are you prepared for the reemergence of market volatility? The persistent low volatility that we have experienced will run its course and reversion to the mean will occur. A quick check of your risk tolerance and current market exposure is a good exercise, because it is important to make sure that your portfolio is not over-allocated to high risk assets, and that it meets your objectives. Rebalancing the portfolio back to its target allocation will reduce unintended exposure to high risk-assets. Studies indicate timing the market is not an easy exercise, so it’s important to prepare your portfolio for all market conditions.
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