Feeling uneasy? Three potential strategies for navigating market volatility

A perspective from E*TRADE Securities 05/17/19

It’s been a while since investors had that queasy feeling but, like a bad dream, it made a brief comeback over the past two weeks. Before recovering, the Dow 30 industrials retreated by 617 points on Monday—the worst day for the index since early January and a continuation of last week’s tumult that saw the S&P 500® retreat by more than 2%.

At issue is an escalating trade war that has been heating to a boil since last year when the Trump administration imposed $250 billion in tariffs on Chinese imports. By most indications, the two sides were close to a resolution before talks fell off the rails last week, followed by the tailspin we saw in the equity markets.

When the waves get choppy

It’s times like these that investors’ mettle is tested. Experienced investors understand that volatility comes with the territory, but even the pros take steps to minimize the fallout from periodic market corrections.

For those investors tempted to flee for the exits when the markets go south—or even those who have an iron constitution but would like to limit price fluctuations, here are three strategies that could help you get a better night’s sleep.

1. Increasing fixed income exposure

Stocks are one of the best long-term wealth-building tools to be found, but they carry risk, and an equity-heavy portfolio is bound to provide some stomach-churning rides.

High-quality bonds—typically in the form of US Treasuries and money market securities—are built for capital preservation and consistent but limited income generation. They don’t carry the upside potential of equities, but they may reduce the highs and lows of the stock market and provide some measure of cushion when conditions get rocky.

When paired with stocks, bonds allow investors to participate in market gains, while potentially mitigating the effects of market corrections—although long-term returns may also be clipped.

Consider two recent scenarios as an illustration:

Source: Morningstar, Inc.

As you can see, a basic 60/40 split can limit upside potential, but can also provide a degree of protection on the downside.

2. Combining asset classes with low correlations

So far, we’ve only considered large-cap stocks and high-quality bonds—a limited worldview, to be sure. There are a host of other asset classes from which to choose, including small- and mid-cap US stocks, international equities, commodities, and high-yield bonds.

The key to reducing volatility is blending a mix of asset classes with relatively low correlations—i.e., assets that don’t tend to move together in lock step. For example, large-cap growth stocks have a low correlation with investment-grade bonds. When one goes up, the other may go down—or at least not advance to the same degree.

Combining assets with low correlations also has important implications for portfolio diversification. Here are some asset classes with relatively low correlations with large-cap growth stocks. The lower the correlation figure, the less likely the two assets are to move together (1.000 implies perfect correlation, while 0.000 implies no correlation whatsoever).

Asset correlations with large-cap growth stocks

Source: Morningstar, Inc.

3. Dividend stocks

Dividend-paying stocks allow investors to participate in the success of a company by receiving regular dividends funded from a company’s earnings. Dividends are an important source of total return, and when the equity markets tumble, it can be beneficial to have dividend-generated income to offset price declines.

It helps to do some digging into a company’s dividend history to see how stable the issuer’s dividends have been and whether they’ve increased over time.

In addition to the income they generate, dividend-paying stocks are typically issued by large companies with stable earnings and cash flow.

Understand your investment parameters

While these strategies can help mitigate market volatility, investors should always consider them in the context of their own individual time horizon, risk tolerance, and long-term financial goals. Periods of market volatility provide the opportunity to reassess just how much risk investors are willing to take.

Also keep in mind that some asset classes, like commodities and corporate bonds, can be difficult for individual investors to access. For that reason, investors may wish to consider mutual funds and ETFs, which are convenient, liquid, and include a wide range of holdings within each fund.

The past weeks are a reminder that investing can at times be a carnival thrill ride. But if you’d like a little more Ferris wheel with your Kingda Ka, these three strategies may be worth considering.

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