Managing Risk in a Volatile Market

As concerns mount surrounding the number of new Coronavirus cases and hospitalisations across the US, volatility has begun to re-emerge across financial markets. The possibility of further wild swings in equity prices is a distinct likelihood, owing to all the uncertainty that lies ahead.

Last week, stocks suffered their worst day since March, with the Dow Jones diving over 1,800 points. While the Dow pared those losses the following day, US stocks oscillated wildly again overnight. In the space of just a few days, the CBOE Volatility Index has soared more than 60%.

As with any period of prolonged uncertainty, one should maintain a flexible and responsive approach to investing. Let’s take a look at some of the strategies that one might employ to manage risk in a volatile market.

Hedging positions

Hedging is a form of risk management designed to mitigate and protect the value of a portfolio from any unforeseen events. One asset is used to offset movement in the value of another asset, avoiding the need to try ‘time’ or ‘predict’ market movements. This strategy offers exposure to price movements that might oppose the core positions in a portfolio and thus reduces downside risk. There are various forms of hedging strategies.

Put options held over a stock or index can offer downside protection by providing you with the right to sell a stock (or benchmark index) at an agreed price should the underlying asset fall.

Alternatively, you may wish to consider inverse ETFs, which provide direct exposure to falling equities or even specific sectors. These ETFs can also be leveraged, although keep in mind this comes with heightened risk.

Currency hedging can also help manage risk in a volatile market. Consider the Australian dollar, which has risen sharply over the last couple months. This has had a profound impact on portfolios concentrated in USD-denominated equities, so it pays to diversify currency holdings.

Another option is to sell futures contracts for key indexes to the same value as one’s overall portfolio. This involves an obligation to sell the index at a nominated date in the future for a specified price. These types of contracts can be executed with a small level of margin leveraged for maximum exposure. Due to this leverage, there is significant risk of loss, so these types of positions are generally best-suited as a short-term risk management tool.

Selling out of equities

While in theory the idea of selling out of equities to avoid sizeable drops sounds great, in practice it is not always practical nor precise. Cast your mind back just three months ago. Selling out of equities in March would have crystallised losses ahead of what turned out to be a stunning rally that saw stocks like Amazon (NASDAQ: AMZN) and Apple (NASDAQ: APPL) reach all-time highs.

Trying to pick the ‘top’ or ‘bottom’ is near impossible. Even the best stock pickers get it ‘wrong’ and face criticism. Just recently, commentators have been critiquing Warren Buffett for seemingly selling airline stocks at their low, however, those stocks are now in the firing line again.

If one sells equities too hastily, you can potentially leave further gains on the table by no longer having any exposure in play. Besides exposure to the broader market, it also means that you lose exposure to the developments of individual stocks that might move separate to the market.

Even where an individual does sell out of the market in anticipation of re-entering later, there is no assurance that they will identify or have the conviction to take up that opportunity, especially if the market starts to rally quickly. This also speaks to the notion of opportunity cost, which could be enormous under the current circumstances, with the Federal Reserve printing money and buying billions of dollars in assets daily, and the US government indicating more economic stimulus could be in the pipeline.

Holding all positions

Although it can seem like a daunting prospect in the middle of a recession, holding stocks has proven to be one of the most effective investment strategies in the long-run. The stock market has always trended higher, while the impact of dividends and compounding returns is near immeasurable.

Based on data going back to 1930, if investors sat out the S&P 500’s best ten days of each decade, total returns would be just 91% compared with nearly 15,000%. Even if you are exposed to sharp falls in the market, retaining exposure to the accompanying upswings has been invaluable.

Holding positions also ensures that you are still leveraged to material news flow relating to a company’s operations. For example, consider the numerous companies vying to be first-to-market with a Coronavirus vaccine, which if successful, would transform a company overnight. Even amidst market volatility, there are still individual stocks or sectors that can outperform. This includes the likes of companies with defensive qualities such as Costco (NASDAQ: COST).

Dollar cost averaging

Another investment strategy that seeks to take advantage of prolonged market volatility is dollar cost averaging, where one invests a consistent amount of money into a stock at regular intervals.

In a falling market dollar cost averaging can have the benefit of helping lower one’s average and reduce risk insofar as the timing of any buying activity. This strategy is most effective where it is anticipated that a stock’s performance has been temporarily hit by something outside its control, with its long-term prospects remaining sound.

Although this strategy can help maximise gains should equity prices eventually move higher, there may be some opportunity cost involved by committing to existing holdings rather than identifying other stocks that could be trading at a depressed price and offer more upside.

One other thing to consider is that this investment strategy has traditionally underperformed against lump-sum investing during rolling 10-year periods dating all the way back to the 1920s. However, in the decade between 2000 and 2009, which featured the tech bust, 9/11 and GFC, dollar cost averaging proved a rewarding exercise for those still holding shares today.