If Monday’s Stock Market Selloff Got You Feeling Anxious, Here Are The Best Ways To Settle Your Nerves

If Monday’s Stock Market Selloff Got You Feeling Anxious, Here Are The Best Ways To Settle Your Nerves
Andrew Rummer

over 2 years ago5 mins

  • If you’ve only been investing for a few months, it’s worth bearing in mind that stock markets aren’t always as benign as they have been this year.

  • If you think a pullback may be on the cards, you could sell up, put more emphasis on safer investments, try put options, or invest in the VIX.

  • And if you’re in this for the long term, you can sit back and relax: these bumps should work themselves out eventually.

If you’ve only been investing for a few months, it’s worth bearing in mind that stock markets aren’t always as benign as they have been this year.

If you think a pullback may be on the cards, you could sell up, put more emphasis on safer investments, try put options, or invest in the VIX.

And if you’re in this for the long term, you can sit back and relax: these bumps should work themselves out eventually.

Mentioned in story

It’s been a year of remarkably benign conditions for stock market investors, but Monday’s sudden drop was a bracing reminder that stocks aren’t guaranteed to keep going up. And if it’s snapped you out of your rose-colored stock market gaze, you might want to start thinking about a few ways you can fight back.

What’s been happening?

The S&P 500, the benchmark gauge for US stocks, fell by 1.6% on Monday – the biggest decline in two months. After such a prolonged period in the green, any hint of red can knock stock market investors off balance, and we certainly witnessed plenty of Finimizers in our group chats getting a little edgy. 

But declines of this size are really nothing to write home about. Stocks, after all, are an investment offering relatively high reward in return for relatively high risk. But after a year where US stocks have gone without a peak-to-trough drawdown of more than 5%, it’s easy to forget what constitutes a serious stock market drop. A quick look back through history, though, shows how rare such stability is.

Chart of S&P 500 drawdowns over the past decade
S&P 500 drawdowns over the past decade

Another way of quantifying this market calm is to chart so-called realized volatility – also known as historical volatility. As the chart below shows, the S&P 500’s average move over the past 60 days is well below its five-year average.

Chart of S&P 500 realized volatility
S&P 500 realized volatility (five-year average shown in red)

Combine this low realized volatility with rising prices, and you get the perfect conditions to maximize one of the key measures of investing success: risk-adjusted returns.

What are risk-adjusted returns?

When professional investors assess their portfolio’s performance, they don’t just look at how much the nominal value of their holdings has grown – i.e. their absolute returns. They’ll also consider their absolute returns divided by the volatility of their portfolio – i.e. their risk-adjusted returns. Put simply, the pros consider a top investment portfolio as one that’s climbed in value while not suffering from too many disconcerting price swings. 

One of the most popular measures of risk-adjusted returns is the Sharpe ratio, where a higher ratio equals a better risk-adjusted return. The current Sharpe ratio for the S&P 500 is among the highest-ever readings in data going back six decades, which means it’s not all that hard to be a “great” investor at the moment.

Chart of S&P 500 Sharpe ratio

Look closer at this chart, however, and you’ll also notice that Sharpe ratios this high don’t tend to stick around for long. History suggests that a reversion to the mean – via weaker overall returns, increased volatility, or both – will hit markets eventually. And it could take your portfolio with it.

If that’s true, how can I protect my investments?

No one can say for sure when markets will rise or fall, but there are a few ways you can insulate your portfolio from losses if Monday woke you up to the possibility of another – potentially much more severe – selloff in the stock market. 

Perhaps most obviously, you can sell some stocks to take profits and reduce your exposure. Just be aware that plenty of studies have shown investors are notoriously bad at timing these dips into and out of the market. You don’t want to become a statistic. 

Instead of selling, you can shuffle your portfolio towards the safer parts of the market. Profits in industries like utilities and consumer staples are generally more protected during tough times, so they tend to fall less than those of the rest of the market. 

You could also consider options. “Put” options give you the right to sell a stock – or an entire index like the S&P 500 – at a predetermined price, known as the strike price. Buying a few puts will help offset losses elsewhere in your portfolio should stocks rapidly head south. The downside, of course, is that you’ll lose all the money you paid for them if the stock or index remains above the strike price when the option expires. And you’re unlikely to be the only one attracted to the safety of puts: look at what happened to trading volume in puts relative to calls as stocks fell on Monday. 

Chart of put/call trading volumes

Finally, you might want to use the Volatility Index (VIX). The VIX measures implied volatility – that is, “fear” in US stock markets, inferred from how much investors are willing to pay for options. The VIX tends to jump whenever stocks slide.

You might be able to directly buy futures contracts on the VIX as protection, if your broker offers them. Exchange-traded products that track the VIX are more widely available, but you should only hold them for a day or two. That’s because over time they’ll lag further and further behind the index they’re supposed to track, due to the cost of rolling over the underlying futures contracts. Just look how iPath’s popular VIX ETN (ticker: VXX; shown in blue) compares with the VIX (in pink) over the past three years. 

Chart of VXX deviation from VIX

But what about the long term?

Plenty of studies have shown that jumping in and out of markets can hurt your returns. We all like to think we’ll sell near the highs and buy back in near the lows, but in practice it’s easier said than done. 

If you’re investing for the very long term – for retirement, for example – you might be best off kicking back and trying as hard as you can to avoid the day-to-day buzz of market moves. If you’re using dollar-cost averaging to add a little to your investment pot each week or each month, you’ll iron out the bumps automatically – without having to resort to too many panic measures. 

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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