Wow, this last week was quite the roller-coaster week in the market. I haven't seen it this volatile in a while. Also, based on the political bickering in Washington and the fear on Main Street, I fear this volatility may be here for a while.
So, what should an investor do in this type of market? Get out? Stay in? Take advantage? Well, here are some things to think about!
How and Why Are You Investing
Market volatility will happen! It is happening now, it has happened in the past, and it will happen again going forward. However, if you have a clear investment strategy in place, it will be easier to live with. Some things to think about are your investment goals, time horizon, and risk tolerance. If you need the money in the next few months, you definitely should NOT be investing it. Even if you need it in the next 3-5 years, it may not be wise to invest it.
Also, what are you goal? Capital appreciation, income, both? This will determine what assets to own. If you only care about income, market volatility shouldn't phase you, as long as you keep receiving the same income.
Both of these play into risk tolerance. This is your decision: Get out? Stay in? Take advantage? If you are risk averse, maybe you want to get out and put your assets into something 100% safe, such as a bank CD. If you have a clear long-term strategy, there is probably no harm in staying in. Finally, if you are an aggressive investor with a high risk tolerance, you may want to take advantage!
The Risk Adverse
If you are risk averse, you hate to see the stock market go down. But it will happen! It is important to note that there is also risk in not being in the stock market – the risk of losing potential gains and your assets not keeping pace with inflation. However, if you can't sleep at night because the DOW drops 200+ points, the stock market may not be for you!
The Long Term Investor
So, you're not risk averse, but you're not a gambler, that's okay! What should you do now with volatility returning to the market? First, make sure that you are diversified. Make sure that you own both stocks and bonds, and even short-term cash holdings as well. In each bucket, make sure you are also diversified.
Stocks: Small Cap, Mid Cap, Large Cap, International, Emerging Markets
Bonds: Short Term, Long Term, Corporate, Government, International, and Municipal
Cash: CDs, Floating Rate Funds, Money Markets
By diversifying, it doesn't necessarily guarantee profit, loss, or break even. Historically, the more diversified a portfolio, the better able it was to sustain a market downturn. Not all asset classes rise and fall together, and diversification takes advantage of this.
Finally, remember that you are in it for the long-haul. Do better on average over time, not just this month or last.
The Aggressive Investor
Do you want to take advantage of the market volatility? This is for you!
The best way to take advantage of volatility is through options. First, you can write covered calls on underlying positions. This allows you to create an income stream with less risk of the strike price being passed (due to the volatility). You can also buy Puts against positions you have, to act as a hedge against further downturn.
Next, you can initiate a straddle (you buy a call and a put with the same strike price and date). The reason you would want to do this is because you can profit from both upward and downward motions, as long as they exceed the appropriate strike price. The loss here is if the market doesn't break out of the range. However, the loss is limited by the call/put spread.
If you feel the market will go a little more one way than another, you can initiate a ratio back spread. This can be put or call, based on your market view of up or down. You profit in both directions if the market breaks out, but your profit is limited by your choice. It is unlimited in the direction you choose. For a call ratio back spread, you would sell a call at a lower strike price and buy two more at a higher strike price. By receiving your credit, you offset your maximum loss.
In this market, it is essential to know what kind of investor you are. Are you adverse to seeing the DOW drop? You don't really mind since you are looking at it over the long haul? Or do you want to profit from it? Maybe you are a combination of the three?
I know that it can be fun to have play money, which you can be more aggressive with, versus having everything investing in a diversified portfolio.
So, readers, what are you? What you doing right now with the markets in turmoil?