Volatility Is Not Your Enemy

Wanderer
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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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Well, this has been an exciting few days in the stock market hasn’t it?

On Friday, February 2nd, the Dow Jones plummeted 666 points, the single worst performing day of the stock market in Trump’s presidency.

On Monday, February 5th, the Dow did even worse, slumping another 1175 points, marking the biggest one-day drop (in # of points) in the Dow Jones’ history.

And then on Tuesday February 6th, the Dow opened down another 567 points, only to close up 567 points, for a stunning 1134-point intra-day swing.

This has caused no shortage of breathless commentary from wheezing talking-heads on TV predicting everything from the start of a bear market to a once-in-a-lifetime buying opportunity you’d be a fool to miss out on.

So what the Hell’s going on here?

Volatility Isn’t Unusual

First of all, the rather extreme reaction in the media is a reminder of just how complacent we’ve become. Despite a, shall we say, unconventional presidential election, the stock markets have gone for over a year without any multi-day triple-digit price decline on the Dow, and that’s gotten many people to forget how unusual that is.

The Chicago Board Options Exchange created an index called the VIX, which uses the spread of options prices to measure the predicted volatility on the stock market. Here’s what it looked like over the past year.

Wow, look at that big scary spike over on the right there! Looks pretty unusual, doesn’t it?

But if we just drag out the time scale over to the past 5 years we see a totally different picture.

Now we see a totally different picture. Yes, that spike on the right still looks unusual, but the real unusual bit has been the extended period of low volatility we’ve seen over the past yet. Nowhere else in the past 5 years has the stock market been that calm for so long. So in that context, a burst of volatility doesn’t seem that unreasonable, does it?

No Reason To Panic

There is a time and a place to panic. If you’re being chased by a T-rex, for example. Or a UFO has just landed in downtown NYC. Or Justin Bieber’s coming to town. Those are appropriate times to crap your pants and take stock of everything you’ve done wrong with your life.

Why God Why?!?

To be fair, 1000+ drops on the Dow are fairly unusual. The last time I remember that happening was in 2008/2009, and back then banks were falling over and the global financial system was on the verge of collapse. Back then, the US housing market crash was in full swing and a certain degree of panic was warranted since nobody quite knew how the whole thing was going to play out.

But now? The prevailing narrative to explain this sudden crash has been somewhat muddy. The first day of volatility was brought about by the announcement that American had created another 200,000 jobs in January, with wages going up 3% YoY, the fastest pace of wage growth in some time. Announcements like these are usually met with cheers from stock investors as it means the US economy is growing, but this time it brought about concerns that the expansion would cause inflation to spike, which would cause the US Federal Reserve to raise interest rates too fast. This in turn caused bonds to drop anticipating a rise in yields, which caused people to sell stocks because higher bond yields made stocks less attractive.

So the prevailing narrative is that stock markets were plummeting because…the economy was…too strong?

Don’t think too hard about this stuff. It’s the media’s job to spin a neatly packaged explanation for every global event that fits inside a 1000-word article, when the reality is that sometimes the explanation is far too complex to explain in a single article, or sometimes, like in this case, no real explanation exists.

When things are going well, money floods from bonds into stocks. When things are going poorly, money floods from stocks into bonds. But when money floods out of both stocks and bonds into cash, that’s usually a sign of fear. Nobody knows where to put their money because everything looks like it’s on fire. I saw days like that where the normal anti-correlated relationship of stocks and bonds completely broke down during the 2008/2009 crisis, and back then fear was palpable in the air. But now? It doesn’t make any sense.

It’s far more likely that somewhere out there, some trading algorithm hit some limit for either stocks or bonds that it deemed “overbought” and decided to start dumping onto the market, which caused a whole bunch of other trading algorithms to pick up on the downward momentum and join in. Market moves like this are typically highly emotional in nature and the predominant emotion among experts being quoted in the media is not fear, but bewilderment.

Structure Your Life So You Don’t Care About Volatility

There are generally two phases in your investment career you can be in when dealing with a sudden spike in volatility: Accumulation and Retirement.

If you’re in the Accumulation phase, meaning you’re still working and building towards your FI target, then the answer is simple (but not easy): When you get your next paycheck, buy into the storm.

It’s a simple but ridiculously scary strategy, especially if this is your first crash. I remember distinctly the experience of putting $1000 into the market in the midst of the 2008/2009 financial crisis, and then the next day having my ETFs be worth $1000 less. I was like “Where the [email protected]%* did my money just go?!?”

But because I was picking up units at a cheaper price, when the recovery did happen, I recovered faster than the overall market and as a result I ended up getting all my money back in just a single year.

And in Retirement, volatility can be hedged using a combination of the Yield Shield and a Cash Cushion.

The Yield Shield gets created when you swing your post-retirement portfolio towards higher-yielding assets like Preferred Shares, REITs, and Corporate Bonds. It increases your overall portfolio volatility (since these are riskier assets) but the yield on your portfolio goes up. We were able to get ours up to around 3.5% when we retired.

And because your yield gets locked in at the moment that you buy, that part is no longer affected by volatility. For example, if your initial portfolio was $1M and you locked in a yield of 3.5%, you’d be yielding $35k a year. Even if your portfolio were to drop to $900k, your portfolio would STILL be yielding $35k a year, or an effective yield of 3.9%.

Combine that with a Cash Cushion that insulates you from sustained market drops that force you to sell at a capital loss, plus Geographic Arbitrage that allows you to drop your living expenses by half by moving to a low-cost locale, and you never have to worry about volatility wrecking your retirement ever again!

Don’t Panic

So in short: Don’t Panic. Nothing bad is happening in the world economy that would suggest a bear market’s coming, and even if it were, structure your life so you no longer have to care about the daily gyrations of the stock market like we did.

So what are your thoughts on this sudden drop in the markets? Let us hear in the comments below.



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40 thoughts on “Volatility Is Not Your Enemy”

  1. Good or bad, I generally ignore the news. So I didn’t know about these huge drops until speculation and tweets about ‘don’t panic’ started coming up in my feed.

    My only thought is Sweet! It’s my first huge drop and panic didn’t even register. Guess I was right about my risk tolerance. Now, on to taking advantage of the sale and buying as per schedule!

    What I do worry about? If the economy changes and affects the job market. If there’s a less job opportunities because of a recession, that’s something to worry about.

  2. The panic is crazy for just a few bumps in the road. Look, in our time horizon, there are going to be a few downturns. Best to believe in your asset mix…and then just keep investing!

  3. We were 40% equity and 60% bonds. After Friday & Monday, we shifted our portfolio to 60% equity and 40% bonds.
    If it drops further we will switch to higher and higher equity till we have no more bonds left.

  4. I keep this around to look at once in awhile. I received this from a wise long term investor:

    “A couple of thoughts.
    I have an old newspaper clip I saved 30 years ago. It has turned yellow with age.
    It pretty much states once you understand the concept of compounding,reinvesting and time,then you “got it”.
    Share acquisitions is the key. Down markets are just a wonderful opportunity for long term investors.You truly have to focus on that and not waste energy on “Oh how much money I have lost”.
    For me each share in a mutual fund is like an employee that never sleeps.
    I sleep while the army of employees are working for me (Coca Cola, Mcdonald’s cash registers are ringing 24/7)the more shares the more income producing employees.
    It is about the economy,not all the noise.
    Been doing this since 1980 at Dow 850 and bought steadily and still reinvesting to this day.
    It is exactly like running a business.One of my family members said the same to me,that managing my financial life to where it has positioned me today has been like a career that I have enjoyed. Just keep investing if you have decades ahead of you.”

  5. Great post! I was just pissed b/c I DCA into the market once a month and bought on 2/2 instead of 2/5. However, market timing doesn’t work so I’m glad I bought 2/2 instead of 2/1. I agreed with MR, once I see a 15-25% correction, I’d switch up my 60/40 stocks to bonds to more like 80/20 to stock up on lower priced stocks. [see what I did there…. 🙂 ]

    1. Yes, you are still timing the market, doing a massive restructure based on a relatively small correction. What if it does correct 15%, you move 20% of your bonds to equity, and it crashes another 15% ? How will you feel?

      Investing is based on not reacting to market corrections, and an allocation should not be defined by the percentage the market drops, its a self adjusting algorithm.

      Your allocating is based on your risk profile, which is set by examining your investment horizon and seeing how much risk you can accommodate at this point in your life.

      You need to remove the emotion completely… that is investing.

      ” Crap, I sold off my Berkshire, and then it went up another 60%… “thats stock trading and market timing.

      I’m not there yet, I sold my Berkshire and am still kicking my ass…

      This is meant to be constructive, and its ok if you don’t agree.

      cheers

      1. Market timing and understanding the effect of a correction are different. If you are comfortable with a 80/20 ratio but think the market is currently over priced and may correct, there’s no hard and fast rule that says you shouldn’t do 60/40 until a correction occurs. There is absolutely no argument that corrections happen; sitting in bonds until a 10-20% correction comes along isn’t stock trading. It’s biding your time; you could DCA at 60/40 then reallocate to 80/20 once a correction hits at 20% down. It’s the discipline to understand that there is a quantifiable trigger that makes you reallocate and understanding that stocks could still go down further which makes it investing not stock trading. If it was truly an emotionless exercise, you wouldn’t have a “tolerance risk” threshold b/c your tolerance is an emotional response.

        1. Agreed, there is no hard fast rule for changing allocation. But the general idea, is because its a percentage, and not an amount, it should be somewhat self correcting.

          I like the idea of DCA into your balance, up or down, when I was reallocating at the bottom of 2009, this worked well for me, as nobody knew it was the bottom until years later.

          Looks like you have a strategy going for you.

          cheers

          1. I think that’s reasonable. If your risk tolerance changes for life reasons, then you can use market corrections as on-ramps to/from your new asset allocation. I don’t really see that as market timing.

  6. I think it’s unfair that people buying the same stocks as I bought a few months ago are picking them up now for 2 or 3% cheaper. Someone should write a Globe & Mail article about my plight and maybe pay me a discount. 😉

    My real answer: I considered moving up my monthly buy or shovel in some extra cash to take advantage of the drop, but the truth is that I have no idea whether it’ll continue to drop for a few more weeks (or more), or recover very quickly. In the end, I’m just going to keep on my usual DCA schedule.

    It’s a bit of a bummer to watch the portfolio drop, but even having only just started investing ~8 months ago, I’m still ahead of where I’d be after Monday’s drop than if I’d continued to leave my money with the nice lady at the bank.

    1. Ha. Good one.

      I have on occasion done minor tweaks like the one you were suggesting (move up a planned buy to take advantage of a sudden drop) but I’ve called it right about the same amount of times I’ve called it wrong, so I don’t think it made much difference in the end.

  7. it definitely feels counterintuitive not to panic, but i’ve read enough FIRE blogs to know better 🙂

    i was reading some of your posts from the last couple weeks and had a question about the backdoor roth. if you’re somewhere in the 120-130k (approx range) where it is unclear how much you can contribute to a roth unless you do yet another complicated calculation, does it make more sense to just do the trad–>roth maneuver instead of doing the calculation (and ending up with less than the max in the roth anyway)? thanks for your work!

    1. I’d say yeah. Just go a head and do it that way. I was doing Roth conversions well before I hit the limit.

      Then again I’m too lazy for the math in the transition, and if your income is variable why worry about the exact number just do it, it’s a small step to avoid a lot of hassle.

      One caveat, make sure you have a $0 balance in your trad/tax deferred IRAs otherwise you’ll be paying tax on the conversion on a pro-rata basis.

      1. Right. What she said. If you have a non-zero balance in a Trad IRA, you need to transfer that away to a 401(k) first before you attempt a backdoor Roth IRA.

        So I guess it depends on hoc much paperwork is required for your personal situation and which path has the least amount of it…

  8. The key point is to stick with your plan. If you find yourself with the urge to panic and sell, it probably means that your self-assessment of risk tolerance was incorrect!

    (And if you don’t have a plan, then maybe you should draw one up?)

  9. It’s all good. Despite having a hypothetical $10k loss in net worth, the projected income side of things didn’t even budge. Only annoying part is that most of my compensation is company equity, so it ‘feels’ better to have that go at a higher price, even though all I’m doing is shifting company equity to diversified equity, making it all the same either way. Bigger numbers just *feel* better.

    1. Yeah it takes some time to kinda grow out of it. At first it’s even scarier when the numbers are so high (1% moves are $10k+ when you’re a millionaire) but after you get some practice watching the income roll in it becomes easier.

  10. A friend of mine asked on Facebook if anyone else was thinking of shifting immediately to 100% bonds for a few weeks. She and her husband are both aerospace engineers, and probably make cubic yards of cash each week. I posted as polite a paragraph as I could on concepts like ‘asset allocation’ and ‘rebalancing’ and ‘staying the course,’ closing with ‘if we were able to time the market as well as most folks like to believe they could, we’d’ve retired five years ago.’ 😛

  11. A reccession is coming, that is almost certain, how will we know? When we look back and see it… well thats too late.

    So Recession proof your portfolio, and do it now. We are 9 years into a market cycle, markets have tripled, or at least doubled, some index’s are even more. Now is not the time to buy more equity, but rebalance to cash/t_bill/bonds. Mostly to rebalance once the true correction happens.

    My Balance is 50/50, I retire in 5 years and have 2 kids to put thru University. This fits my investment horizon and risk profile. Market crashes 10, 15, 20% Don’t care… (this happened in 2011, did you panic?) Once I see a stable bottom of 6 months, then and only then do I adjust allocations base on my Balance.

    cheers

  12. Keeping calm throughout these periods (and sticking to your plan/asset allocation/etc. etc.) is the goal. How we achieve that is the trick. We’re wired to hate bad consequences more than we like rewards.

    I personally like to see dips in percentage terms rather than point terms. It’s calming to see that what happened on Fri/Mon is really not unusual at all in percentage terms.

    1. It’s about training your mind. If you can hammer home sunk cost and bargain hunting, eventually you start to get really excited when things turn down.

      I still feel a little tug when I see the overall return drop, but then I look at all the wonderful things I can get even more of that will pay me even more money 🙂

      1. So true, I actually know someone whose portfolio is 100% cashable term deposits now and is just waiting for the market to crash so he can take advantage, probably not the best strategy but at least he has the right idea as far as bear markets go.

        I remember hearing a quote by Tony Robbins last year and he was saying something about how silly it is that everyone panics when the market crashes and tries to dump their stock instead of buying more, it’s like all of the stocks have just gone on sale for a huge discount, if it was anything else people would be buying it up like crazy

    2. Yeah oddly enough all assets have been moving up and down at about the same rate so even though my portfolio’s value has moved quite a bit, my percentage numbers haven’t.

  13. getting ugly again. Looks like a minimum 10% correction. Haven’t had a 30% correction since 2008, historically they occur once every 8- 10 years so we are ‘overdue’

    that would test the resolve of many

  14. This isn’t complicated

    What is going on is the Fed managed to snatch the US economy from the jaws of deflation from the 2008 crash by hook or crook, Thank God. All of the financials: equities bonds and credit have been pegged against the wall by Fed action. Interest instruments, Bonds and Stocks are all 90% from their predicted means and as the Fed removes it’s control all three will tend to revert to the mean, but this will cause re-balancing between financials.

    VIX is a stock market measure, so it’s only good at measuring something about stocks. The talking heads like to talk about “fear” but it’s about implied volatility which is a technical measure of how you price options, and options are contracts on the future so it’s not even about volatility as in the common understanding of standard deviation. Of course that bubble-head Liz Clayman spends half of her hour quacking about fear so everybody gets afraid.

    Reverting to the mean is a good thing. Reverting to the mean allows normal ebb and flow. Reverting to the mean says it makes sense to own stocks bonds commodities and interest vehicles (like bank accounts) instead of just stocks which are very risky and it restores the value of non-correlated diversity to the equation. Another name for non-correlated diversity is free money. Free money is a good thing. As stocks become less expensive bonds will become less expensive and return on bonds will rise. As bond returns rise so will interest bearing accounts so what you loose in one one will tend to show up as gain somewhere else. It’s the reason to be properly diversified.

  15. The only thing keeping me calm is I’ve calculated how much in yearly dividends my current portfolio generates, and then divided that by 12 to get an idea of what my monthly income is.

    Otherwise I’d be wandering the house in a bathrobe, lamenting the state of XSP, and crying at the lack of any chocolate in the house. Oh, wait …

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