Wells Fargo strategists noted in a recent report that the recent spike in volatility, as evidenced by the recent rise in the Volatility Index (VIX), is a reminder that market volatility is an integral part of investing.
However, the investment bank advises against responding hastily to these fluctuations by reducing exposure to stocks, stressing the importance of adhering to a well-diversified asset allocation.
In short, strategists argue that volatility should not prompt investors to exit the market or try to time it.
They stress that volatility is not only associated with downturns; sharp spikes can also occur, often in the immediate vicinity of downturns. The note argues that missing just a few of the market’s best days, which often coincide with periods of high volatility, can significantly reduce long-term returns.
“Moreover, over the past 30 years, two of the three most recent bear markets have accounted for nearly all of the worst twenty days and half of the best twenty days, illustrating that the best market days often come when volatility is at its highest,” the report said.
Furthermore, the market’s biggest gains and losses often occur in quick succession, especially during periods of heightened volatility associated with economic recessions or bear markets. For example, between March 9 and March 18, 2020, the market experienced two of its best days and four of its worst days in just eight trading sessions.
Wells Fargo provides more details on the psychological biases that may influence investment decisions during volatile periods.
Biases such as loss aversion, herd behavior, and overconfidence can lead to harmful actions such as panic selling or excessive trading. Strategists emphasize the importance of maintaining discipline and not letting short-term market movements derail long-term investment strategies.
Strategists believe that both tactical and strategic investors can benefit from a diversified portfolio that includes different asset classes with varying levels of correlation.
For tactical investors, the note recommends taking advantage of market turmoil by making tactical shifts – reducing exposure to areas expected to underperform and increasing exposure to areas best positioned to withstand volatility.
For longer-term strategic investors, the key lesson to learn is the resilience of markets over time. Historically, the stock market has rebounded from major downturns, often to new highs.
“For long-term investors, time is on their side to recover from these declines if they remain disciplined,” the strategists added.
“From our perspective, both tactical and strategic investors can benefit by leveraging a diversified allocation that includes a selection of asset classes with varying degrees of correlation to each other.”
In addition, implementing a rebalancing strategy on a regular basis helps ensure that the portfolio remains aligned with the investor’s goals and maintains the desired asset allocation.
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