By Matt Rosenberg, CPA/PFS, member of the AICPA National CPA Financial Literacy Commission
Uncertainty can drive market volatility, and we are currently in very uncertain times. The Coronavirus pandemic has driven market volatility to new highs. Recently it has not been unusual to see the Dow Jones, NASDAQ, and S&P 500 move by 5 percent or more in a single day. On multiple instances trading has been halted for 15 minutes because the S&P has dropped by more than 7 percent during the day. To put that into perspective, the value of the U.S. stock market was approximately $38 trillion as of 12/31/19. A 7% intra-day decline means that over $2.5 trillion of wealth vanished in a single day. Increased volatility means there are also big “up” moves in the market and trillions of wealth is created in a single day. That is why it can be so tempting for investors to start gambling on these big swings and make money by timing the market.
What is market volatility?
The value of a stock is based on the expected future cash flows the owner will receive. Every day the price of a stock changes, moving up and down as investors match their desire to buy those future cash flows with the willingness of current stock owners to sell (supply and demand). Most days the price change of stocks, known as volatility, is small and results in movements up or down of less than 1%. However, life is full of surprises and the ability of a certain stock to generate future cash flows can change rapidly and unpredictably. When these changes occur investors scramble to discover the impact on the future cash flows of the stock and this can result in large price swings in either direction, or increased volatility.
What does it mean to ‘time the market’?
Market timing is the notion that an investor can pick just the right time to buy and sell a stock to make a profit or avoid a loss. Marketing timing involves trading more frequently, possibly even within the same day. Short-term markets movements tend to be erratic and highly unpredictable. Therefore, successfully timing markets to profit from short-term trades is very difficult to do consistently over long periods of time and often relies on speculation.
According to AICPA research, nearly half of U.S. adults (48 percent) believe that a volatile market gives them an easy opportunity to make a profit. Unfortunately, the reality is that profiting from market timing is far from easy and is more likely to cost an investor money.
Investing Vs. Speculating
Investing money is something that should not be viewed as a get rich quick scheme. It’s very important to make the distinction between investing and speculating. Responsible investing involves defining a financial goal and then purchasing a combination of securities that will provide the appropriate risk-return to help achieve that goal.
The risk associated with an investment opportunity is a crucial element to help Americans differentiate between investing and speculating. Investing is usually considered lower-risk and longer-term focused, whereas speculation is high-risk and short-term focused. An investor’s understanding of their own risk tolerance, the potential amount of money they can endure losing, is essential when building a balanced portfolio. The time over which an investment is expected to be held before it is liquidated (time horizon), your net worth, income and the ease in which an investment can be bought and sold (liquidity) all impact risk tolerance.
In addition to knowing your own risk tolerance, investing involves carefully researching business fundamentals such as quarterly financial earnings, profit margins and market positioning to make sure the opportunity fits your portfolio.
Attempting to profit on stocks from short-term market movements is a gamble and more likely to detract from an investor’s long-term financial goals.
How to navigate market volatility
So, what should investors do when markets plummet and volatility spikes? Remember why you are investing. Think about your financial goal(s). If your goal is long-term (i.e. investing for retirement), then being patient is likely your best course of action. Over the last 20 years, many of the market's worst trading days have been within one month of the best trading days.
It’s also important to keep emotion out of investment decisions and ignore financial advice/comments from non-professionals. Watching the value of your portfolio decline can be scary, especially when friends/family are throwing around doomsday predictions. However, selling out of investments at the wrong time can also be a very costly decision. Time in the market often pays off more than timing the market.
Having patience with your portfolio is much easier to do when it is diversified appropriately for your financial goals. Creating a mix of stocks and bonds in a portfolio that is most appropriate for your financial goal can be difficult, so seeking the help of a professional may be a good idea. A well-researched and diversified portfolio that matches your risk tolerance can give you the confidence you need to stay focused on your long-term goals through all the market ups and downs.
Before you invest your hard-earned money, it's important you take control of your financial future and arm yourself with a solid baseline of knowledge. Learning the investing basics, including definitions of key investment terms, can greatly help your ability to determine what investments fit your financial goals.