An Investor's Guide To Market Volatility
Knowing what to do during a market downturn can be especially difficult in the moment. Here’s how to plan ahead.
In 1 minute
When the prices in financial markets change, that’s market volatility. More volatility means greater potential for both gains or losses.
In investing, market volatility comes with the territory. Some days the market is up, and other days it’s down. It’s OK to be anxious during a dip, but preparing for market volatility can help you avoid making decisions out of fear.
Two of the biggest ways you can prepare for volatility:
- Diversify your portfolio
- Build an emergency fund
Diversification helps protect your portfolio by spreading out your risk. A diversified portfolio may not gain as much as some individual assets, but it likely won’t lose as much as others.
An emergency fund is a financial safety net. If market volatility negatively impacts your investments, your emergency fund can help cover your expenses until the economy recovers.
During a downturn, we recommend resisting the urge to change your investments. Give your portfolio time to recover. But if you can’t do that, try to keep changes small, like lowering your stock allocation so that it’s more consistent with a more conservative risk tolerance level. In general, you should invest for the long-term, but at the same time you’ll likely want a diversified portfolio that you’re comfortable holding on to even when things in the market get bad. This can increase the odds you remain in the market when it ultimately recovers and continues on its path of expected long-term growth.
Still not satisfying the itch to act? High management fees or capital gains distributions (from a mutual fund) could make that market volatility more uncomfortable. Or perhaps your financial advisor isn’t sticking to your target allocation as your portfolio experiences gains and losses. In these situations, a lower-fee robo-advisor like Betterment can help alleviate that discomfort.
In 5 minutes
In this guide, we’ll cover:
- What market volatility is
- How to prepare for it
- What to do about it
Nobody likes to see their finances take a nosedive. But in a volatile market, dips happen often.
Market volatility refers to fluctuations in the price of investments. Some markets—like the stock market—fluctuate more than others. And in times of economic stress, markets tend to be even more volatile, so you might see some big ups and downs.
It’s tempting to sell everything and bail out during dips, but that often does more harm than good. Selling your assets could lock-in losses before they have a chance to rebound from the dip, and it’s nearly impossible to predict the market’s high points and low points.
Reacting to market drawdowns by moving to cash is like selling your clothes because you gained a few pounds. Sure, they may feel a little snug, but you could find yourself with a bare closet if and when your weight fluctuates the other way.
Historically, the stock market has had plenty of bad days. In any given decade, you’re bound to see many drawdowns, where investment values dip frightfully low. But when you step back and look at the big picture, the market has trended upward over time. So far, the global stock market, and by extension the U.S. stock market, has always recovered from economic downturns. And while nothing in life is guaranteed, those are some pretty good odds.
History shows us that experiencing short-term losses is part of the path to long-term gains.
The key for investors is to expect market volatility. It’s inevitable. And that means you need to prepare for it—not simply react to it.
How to prepare for market volatility
Market volatility can occur at any time. So you want to be ready for it now and in the future. The main thing you can do to prepare is diversify your portfolio. Having a balance of different assets decreases your overall level of risk. While some of your assets momentarily struggle, for example, others may hold steady or even thrive. The goal is your portfolio will hopefully feel less like a rollercoaster and more like a fun hike up wealth mountain.
Beyond that, you’ll want to strongly consider building an emergency fund. A good starting point is having enough to cover three to six months of expenses. This is money you want on hand if market volatility takes a turn for the worse.
Even if you don’t depend on your investments for income, major economic downturns can affect your life in other ways. The poor economy could lead to layoffs, bankruptcies, and other situations that impact your job stability. Or if you have rental properties, the real estate market could be adversely affected as well. All the more reason to have an emergency fund and ride out that turbulence if the need arises.
What investors should do during downturns
Caught in a downturn? Don’t panic. Seriously, when the market looks grim, the best reaction is usually to do nothing. Selling off your portfolio to prevent further losses is a common investor mistake that does two things:
- It locks-in those losses
- It takes away your chance to rebound with the market
Scratching an itch usually won’t prevent it from recurring. The same goes for reacting to short-term losses in your portfolio. As much as you can, you want to resist the urge to react.
Still, sometimes you may feel like you have to make a change. If that’s you, the first thing to do is make sure you’re comfortable with the level of risk you’re taking. Some asset classes, like stocks, are more volatile than others. The more weighted your portfolio is toward these assets, the more vulnerable it is to changes in the market. You’ll also want to confirm that your time horizon (when you need the money) is still correct.
Think of this like checking your pulse, or taking a few deep breaths. You’re making sure your investments look right—that everything is working like it’s supposed to.
If you’re still feeling tempted to do something drastic like withdraw all your investments, you probably should reduce your level of risk. Even if everything looks right for your goals, making a small adjustment now could prevent you from making a bigger mistake out of panic later. Your pulse is too high. Your breaths are too rapid. Sitting at 90% stocks and 10% bonds? You might try dialing it down to 75% stocks and 25% bonds.
The time may be ripe to consider a Roth conversion
Our investing advice of doing nothing and staying the course is generally the direction we try to nudge you toward when markets are down. While drops in global markets can be stressful, they also provide opportunities that can be beneficial for future you.
One of those strategies is implementing a Roth conversion. A Roth conversion allows you to transfer, or convert, funds from a traditional IRA to a Roth IRA. You will typically owe income taxes on the amount you convert in the year of conversion, but the tradeoff is that once inside the Roth IRA future growth and withdrawals are generally tax-free. You can take a look at other pros and cons of Roth conversions in our Help Center.
Here are a couple of reasons why you may want to consider converting your IRA when the market is down:
- The balance of your Traditional IRA has dropped significantly. When the balance of your Traditional IRA drops, you’re able to convert the same number of shares at lower market prices. This means you may pay less in taxes than if you converted those same number of shares at higher market prices.
- Growth from a global market recovery can be better in a Roth IRA than a Traditional IRA. As global markets recover over time, the value of your converted holdings may increase. This increase in value will now take place in your Roth IRA. Down the line, when you start taking withdrawals out of your Roth IRA in retirement, you’ll be able to do so without incurring any taxes.
To understand how a Roth conversion may impact your personal financial situation, we strongly recommend consulting a tax advisor and IRS Publication 590. Betterment is not a licensed tax advisor and cannot provide tax advice.
Reassess where you invest
Depending on your situation, another option might be to shift your investments to a financial institution like Betterment. This could save you money in other ways, which might make your current risk level feel more comfortable. Some signs this might be the right move for you:
1. Your accounts have higher management fees
You can’t control how the market performs, but you don’t have to be stuck with higher fees. Switching to a lower-fee institution like Betterment could lead to less of a drag on your long-term returns.
2. Your allocation is incorrect
The sooner you need to use your money, the less risk you should take. Not sure what level of risk is right for you? When you set up a financial goal with Betterment, we’ll recommend a risk level based on your time horizon and target amount.
3. You own mutual funds that pay capital gains distributions
When a mutual fund manager sells underlying investments in the fund, they may make a profit (capital gains), which are then passed on to individual shareholders like you. These distributions are taxable. Even worse: mutual funds can pay out capital gain distributions even if the fund’s overall performance is down for a year. So in a volatile market, your portfolio could lose value and you may still pay taxes on gains within the fund. In contrast, most exchange traded funds (ETFs) are more tax efficient.