The recent increase in volatility, as evidenced by the recent rise in the VIX, is a reminder that market fluctuations are an inherent part of investing, Wells Fargo strategists noted in a recent report.
However, the investment bank advises against reacting prematurely to these fluctuations by reducing equity exposure and stresses the importance of maintaining a well-diversified asset allocation.
In short, strategists argue that volatility should not cause investors to exit the market or try to find the right time to do so.
They stress that volatility does not only accompany downturns; sharp upswings can also occur, often in close proximity to downturns. The note underscores that missing just a few of the market’s best days, which often coincide with periods of heightened volatility, can significantly reduce long-term returns.
“In addition, two of the three most recent bear markets of the past 30 years accounted for almost all of the 20 worst days and half of the 20 best days, further illustrating that the market’s best days often come when volatility is highest,” the report said.
In addition, the largest market gains and losses often occur in rapid succession, especially during times of increased 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 within just eight trading sessions.
Wells Fargo explains in more detail the psychological tendencies that can influence investment decisions in volatile times.
Biases such as loss aversion, herding behavior and overconfidence can lead to harmful actions such as panic selling or excessive trading. The strategists stress the importance of maintaining discipline and not allowing short-term market movements to undermine 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 degrees of correlation.
The note recommends that tactical investors take advantage of market dislocations through tactical price changes, such as reducing exposure to areas expected to underperform and increasing exposure to areas better able to withstand volatility.
For long-term, strategic investors, the most important insight is the resilience of markets over time. The stock market has a history of recovering from significant downturns and often reaching new highs.
“Long-term investors have time to potentially recover from these downturns if they remain disciplined,” the strategists continued.
“We believe that both tactical and strategic investors can benefit from a diversified allocation that includes a selection of asset classes with varying degrees of correlation to each other.”
In addition, implementing a regular rebalancing strategy helps ensure that the portfolio continues to align with the investor’s goals and maintains the desired asset allocation.
