June 2, 2010 / 5:14 PM / 7 years ago

PersonalFinance: Riding out market volatility

WASHINGTON (Reuters) - If you’re losing sleep over the stock market, you’re not alone. Volatility has gone through the roof, while prices have gone the other way.

<p>A trader holds his head as another reads a paper after markets closed in the natural gas feature pit of the New York Mercantile Exchange in New York June 6, 2008. REUTERS/Joshua Lott</p>

It was the worst May in almost 40 years for U.S. stocks, and included several days of 200-plus point swings in the Dow Jones Industrial Average. One day the Dow plunged almost 1,000 points in an hour, and another day it fell more than 200 points in the opening two minutes. It’s not over, either.

“Nervous investors and slowly receding uncertainty levels will keep market volatility high over the coming month,” Bob Doll, chief equity strategist at investment management firm BlackRock, said on June 1, echoing the sentiments of many other market watchers.

There is an index that monitors stock market volatility. Colloquially called “the VIX,” it is an index of options contracts on the Standard & Poor’s 500 stock index designed to predict S&P volatility over the next 30 days. And it’s high right now. After bouncing around mostly below 20 for the first four months of this year, it spiked over 40 twice in May and remains in the mid 30s. We can expect more of the same.

Conventional wisdom holds that individual investors should not do anything about volatile markets; we are just supposed to buy and hold -- and hold, and hold, say the experts. That’s not entirely wrong. Individual investors do have a way of buying high and selling low, and panicking when the markets panic.

But it’s not entirely the right advice, either. There are ways you can protect yourself and even capitalize on volatile periods. Here are some strategies:

-- Do some trading. I am not suggesting you time the market; that doesn’t usually work well for individual investors. But if you’re holding shares that would net you a tax loss if you sold them, you might as well sell and take the loss. You can rebuy the same securities after a month. If you don’t want to wait that long, buy something else with the money.

It also makes sense to be more vigilant about the target prices of your holdings during volatile periods. If something you own has already exceeded your target price, you might as well sell it on an up day. Similarly, if you have a shopping list of investments you’d like to own, wait until one of those miserable sell-off days to place the buy orders. If you’re simply rebalancing a mostly stable portfolio, place your buy and sell orders on days when the market is moving in your favor.

-- Dollar cost average or value cost average. When you use a strategy called dollar cost averaging, it means you invest the same exact amount at the same exact interval in the same mutual fund. So, for example, you might have $50 of every paycheck put into a stock fund in your 401(k) account, or have $200 a month automatically invested in your child’s 529 college savings plan. That really works for you in a volatile market. During down times, your regular contribution buys more shares and lowers your average cost per share. The more volatile the share price, the better it works for you.

You can boost your returns even more by value cost averaging: That’s a little more complex but it can magnify your results. To value cost average every month, adjust the amount you contribute regularly by the percentage gain or loss in the price of the security since your last purchase. So, if you sent in $100 in one month to buy a stock index fund, and by the next month, it had fallen 4 percent, you would send in $104 the next month. If, by the following month, the price had risen 5 percent, you would send in $99 ($104 minus 5 percent.)

-- Hunt for good dividend stocks. Companies that pay out solid dividends can be a good investment during rocky times. It's as if that dividend is your reward for waiting for the stock to climb. And in volatile times, the share prices of stocks can fall to the point where the dividend yield on a stock is approaching a bond yield, says Harry Domash, publisher of Dividend Detective (www.dividenddetective.com.) Look for solid companies that seem healthy but dropped with the rest of the market. And be aware that astronomical dividend yields (12 percent, say) probably don't signify a bargain so much as they warn that a company is in trouble and may be about to cut its dividend.

-- Be careful about some protective strategies. Some investment advisers tell clients to place “stop loss” orders on their stocks and ETFs. These orders instruct your broker to sell if the share price falls to a certain point -- say, 10 percent below the current price. The idea behind this is that it will protect most of your profits and get you out of a stock before it tumbles too far. For example, if you own a company selling at $50 a share and you put in a stop order at $45 -- your position would be sold if the stock price fell that far.

Here’s what’s wrong with that: Your broker may not be fast enough to execute the trade at that price, and once the price falls below $45, that stop order becomes a sell order. Should the price tumble to $1 a share in an hour (That happened to some companies on May 6, remember?), you might end up having sold your shares at $20 or $10 or even $1, and miss the bounce back up.

If you choose to go this route, don’t use a stop order. Use a more complex strategy called a stop limit order, which would also allow you to set a floor for your sale price. So, you could order the shares sold between $35 and $45. But it’s entirely possible that on a really bad day, the price would fall so fast, your order would never get executed. Another risk? With volatility at peak levels, a 10 percent stop order might not be enough. You might end up sold out of stocks you want to own when they dip just before rising.

-- Linda Stern is a freelance writer. Any opinions in the column are hers. You can follow Linda Stern's financial notes on Twitter at www.twitter.com/lindastern)

Editing by Gunna Dickson

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