In February and March 2020, as the Coronavirus pandemic was in its early infancy, professional investors, traders and economists were unsure about the impact it would have on the global economy, and on risky investments like stocks, bonds and real estate. In a matter of just a few weeks, the major global stock market indices dropped by 30-40% or more, depending on the asset class.

In late March, though, stock market indices rebounded almost as quickly as they had declined. By mid-May the indices has recouped their losses, and 11 months later most, if not all, were at record high levels.

What lessons can investors learn from this most recent episode of market drama?

Let’s first review what market volatility represents, and then consider some strategies to take advantage of it, as well as some potential pitfalls to avoid.

What is Market Volatility

At Springwater Wealth, one of our favorite sayings about successful investing is, “Short-term bumps in the road are the price you pay for long-term growth”. Most investors need to earn returns on their investments that exceed future inflation, and the ability to tolerate short-term gyrations in the value of your portfolio is an unavoidable part of that process.

There are different ways to think about investing risk. One example is the risk that your investments don’t grow enough over time to fund your goals, like college for your kids, retirement, or charitable giving. But the most common measure of investing risk is the variability of an investment’s returns. This is known as standard deviation, which in the context of investing measures the degree of dispersion of a set of returns around their average.

When we look at historical data for a particular risky investment, or for a portfolio that has a meaningful exposure to stocks, we see that the returns vary – often dramatically – from period to period. For example, here are the monthly returns for the Dimensional Small Cap Value mutual fund (ticker symbol DFSVX) for the six-month period November 2019 to May 2020:

Month Return
November 2019 + 3.17%
December 2019 + 3.92%
January 2020 – 6.88%
February 2020 – 10.79%
March 2020 – 26.60%
April 2020 + 15.81%

If we knew for certain when we would receive positive or negative returns, we could successfully time our buy and sell trades, and make exceptionally high profits with little risk. Unfortunately, no one has a crystal ball to predict the future, and so those who try to “time” the market are speculating, not investing. The many reasons why so-called “active management” is a strategy doomed to fail goes beyond the scope of this piece, but suffice it to say that attempting to earn high returns with no risk is a fool’s errand.

So, we know what market volatility is, and – by looking at a set of recent returns for the fund DFSVX – how it manifests itself. Let’s now explore how investors can capitalize on it.

What Opportunities Are There

Most everyone is familiar with the expression, “Buy low, sell high”. And in the context of investing, it makes complete sense – why would anyone intentionally sell something for less than what they paid for it?

Setting aside unfortunate situations that might require the need to sell investments at an inopportune time, let’s look at three of the most common ways that you can take advantage of market volatility.

Opportunistic Rebalancing

Rebalancing is the process of systematically realigning your portfolio’s mix of investments with their target allocation. Because a well-diversified portfolio will contain investments that perform differently over time, you’ll periodically want to review your actual allocation, and then place whatever trades are needed to bring it back to its target. Why? Because a portfolio that has drifted too much from its target has (potentially much) different risk and return characteristics from the target – possibly too conservative, but perhaps too risky.

Academic studies have shown that annual rebalancing is generally sufficient, and that there’s not a consistent benefit to more frequent rebalancing, like quarterly or even monthly.

But, what about when there’s a period of high market volatility, like we experienced in the first quarter of 2020? Well, that can represent an opportunity for an “out-of-cycle” rebalancing, to take advantage of the fact that certain asset classes may be “on sale”. Looking at our example of the mutual fund DFSVX above, if you had just rebalanced your portfolio in late 2019 and then found that in March it was exceptionally underweight in the asset class “US small cap value stocks”, you could have taken advantage of the opportunity to “buy low”.

The challenge with rebalancing in general, and opportunistic rebalancing in particular, is that self-directed investors generally don’t do a good job of it.

Harvesting Losses

An important feature of the US tax code is that capital losses can, under certain conditions, be offset against capital gains, to reduce the taxpayer’s net tax liability.

How can you take advantage of this during a period of market volatility? Well, imagine that there is an asset class that’s lost value since you last rebalanced, and you find that your cost basis is higher than the current market value – perhaps for some shares, or maybe for all of them. You could sell this holding to generate a capital loss, which loss can be used to offset future gains you may want or have to realize.

But, presumably the asset class you sold to realize a loss is one you want to own long-term, as part of your target asset allocation. Maybe it’s US small cap value stocks, or emerging markets stocks.

Well, the IRS has something call the “wash-sale rule”. In short, the wash-sale rule prohibits you from selling an investment for a loss and replacing it with the same or a “substantially identical” investment 30 days before or after the sale. If you do have a wash sale, the IRS will not allow you to write off the investment loss.

So, to avoid the wash-sale rule, you’d want to find a mutual fund or ETF that tracks a different index but still provides an exposure to the desired asset class. With so many index-oriented funds available, this shouldn’t be too challenging. Vanguard, State Street SPDR, Charles Schwab, BlackRock’s iShares, Avantis, and Dimensional Funds are just a few of the leading index fund managers.

Realizing Gains

If you sell an investment for more than you paid for it, you generate a capital gain. Long-term gains are created when you’ve owned the investment for more than one year, while short-term gains are created when you’ve owned the investment for less than one year. Long-term gains are taxed more favorably than short-term gains.

You might generate capital gains when you periodically rebalance your portfolio. But, there might be other times when you intentionally want sell an investment to realize capital gains. Let’s look at a couple of examples.

Suppose in a given year your income is exceptionally low. This could be a year in which you take an unpaid sabbatical, a year when you’re in between jobs, or a year after you’ve retired but before your Social Security or pension income starts. If your income is low enough, you may pay no capital gains tax at all on the long-term gains you realize. For example, if your 2021 income is below $80,800 as a married couple filing jointly, you’d be in the 0% tax bracket for capital gains. If your annual income is low enough to qualify for the 0% tax rate on capital gains, you’d arguably want to realize as much in long-term capital gain as possible, up to the point where an additional dollar of gain would bump you into a higher tax bracket and cause the 15% capital gains rate to apply.

An added benefit of this so-called “capital gains harvesting” exercise is that you can immediately buy back the same investment you sold without any issues. Doing so effectively resets your cost basis in the investment higher, and so reduces the amount of capital gains you’ll pay in the future.

What Not to Do

We’ve reviewed several strategies for taking advantage of market volatility. But there are things you shouldn’t do when the markets are swinging wildly, too.

First, it’s generally a good idea to avoid consuming too much media when the markets are volatile. There’s not a lot of useful information that can be gleaned from tracking the price movements of a stock, mutual fund, or index on a minute-by-minute basis, despite what CNBC and other purveyors of financial “news” would have you believe. In fact, a strong case could be made that monthly checks of your portfolio are sufficient to keep it on track.

Also, it’s critical to keep your emotions in check when the markets are topsy turvy. An investment policy statement that you put in place with your investment advisor (or on your own, if you manage your own investments) can keep you grounded and focused on the investment strategy you selected. Impulsive decision-making generally doesn’t lead to good results, whereas an objective, dispassionate approach to portfolio management has been shown to serve investors well.

Getting Help

At Springwater, we often tell prospective clients that they need to have four things before they consider managing their own investments: the aptitude (or ability), the attitude (or enjoyment), the time, and the fortitude (or ability to tolerate the inevitable swings).

If you’re unsure whether you have what it takes to properly and prudently manage your own portfolio, or to capitalize on periodic bouts of market volatility, you may wish to consider hiring a Certified Financial Planner® professional or Chartered Financial Analyst to work with.

Do you have questions about your investments? Contact us today to see how our team at Springwater Wealth can help you.