The effects of the economy shutting down from a global pandemic sent the markets into a whirlwind as we entered 2020. The market was at an all-time high February 19th, quickly dropped to the bottom on March 23rd, and has been followed by swings of volatility. As volatility spiked, an unprecedented number of new investors (who were stuck at home) entered the market for the first time, purchasing individual stocks in hopes of getting rich quick. This was exacerbated by new mobile trading platforms that allow extremely low minimum investments.
Professional investors, such as the Pathfinder team, were also making moves to take advantage of volatility for clients. But instead of treating the stock market like a slot machine, seasoned investors make calculated decisions based on their long-term plan. Below are a few key actions savvy investors follow to manage a volatile market.
Build an Emergency Fund
Established investors have an emergency fund in place. An emergency fund protects investors from accessing their long-term assets due to unexpected losses of income or increases in expenses. An adequate emergency fund covers living expenses unique to each household. Basic living expenses are the monthly costs it takes to maintain a household, including mortgage/rent payments, utilities, insurances, food costs, and other fixed monthly expenses. In general, we recommend the equivalent of 3 to 6 months of these expenses for a baseline fund; however, there are unique circumstances where we may recommend more.
Invest Extra Cash
Once you have established your emergency fund, you should think about what’s next. At the start of the “stay-at-home” orders, many of our clients began to build up additional cash, beyond their emergency fund, due to cancelled travel plans and decreased spending on dining out and entertainment. As interest rates dropped and investment values fell, clients sought opportunities to invest their extra cash. This can help get them ahead of their long-term goals. If you are timid to invest the cash in uncertain times, you could consider scaling into the market to take advantage of the volatility. For example, if an investor has $50,000 available to invest, instead of putting $50,000 to work all at once, it may be more beneficial to put a percentage (tranche) of the money to work incrementally. Since there is no way to know the exact market bottom, the market could drop below the price of when the first tranche was invested. Scaling presents the opportunity to put additional tranches to work at various prices. If you put your full amount to work during the first dip of the market drop in late February, you would have no additional cash to take advantage of continued volatility through the market bottom in late March. Scaling also allows you to keep cash longer to gain more confidence to invest.
Investing into one stock or only one asset class is very risky. Instead of putting all your eggs in one basket, we recommend clients remain diversified. Diversification hedges investment risk. A mistake we often see is investors chasing stock or asset class returns from previous years. For example, small-cap equity was the highest performing asset class in 2013 at 38.8%. In 2014, small-cap equity closed the year down 4.4%. If you moved all your investments into small-cap equity at the beginning of 2014 expecting similar returns to 2013, you would have been disappointed in your performance. Past performance does not dictate future returns.
Rebalance Your Portfolio
Another strategy that can help during volatile markets is rebalancing. A common mistake we see is selling positions that have declined to invest into positions that are running up. When a stock increases significantly in a short amount of time, it often becomes overvalued, meaning the price of that stock is above what analysts estimate to be a fair purchase price for that stock. We call this “chasing returns” or “buying high.” Instead, experienced investors do the exact opposite: they take profits from positions that have had recent increases to invest in positions that have not performed as well. In the long-term, we expect quality company stocks that were undervalued or overvalued to return to a “fair” value. By selling your overvalued positions and buying undervalued positions, you can add to your portfolio performance as stocks return to fair value over time. It is often difficult to execute though, as it goes against our natural fear and greed and so rebalancing should be done following a process rather than on emotion. This is how savvy investors buy low and sell high.
At Pathfinder, our clients are financially responsible savers that want to secure a great financial future. Part of that security is having a comprehensive financial plan that lays out a foundation for their goals, providing stability in times of uncertainty and guides investment decisions to fund their future. This helps our clients know how much they can afford to invest when opportunities arise during volatile times.
The saying “one size fits all” doesn’t work for shoes and it doesn’t work in finances. Completing a financial plan that is specific to your needs and goals will help establish a path to financial independence. If you are ready to get started, give us a call at 910.793.0616. We are here to guide you forward.
Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved.