Have you noticed how much the stock market has been moving lately? Swings of 1% or more have become normal.
If volatility makes you want to take action and protect your investments, you’re not alone.
For every $100k in your portfolio, 1% represents a gain or loss of $1k. For most of us, that’s more money than we make in a day!
If you’re nearing Financial Independence (FI), you may have $1 million or $2 million in stocks. Every 1% is a gain or loss of $10k or $20k in your case. That’s more than most of us make in a month!
Volatility can be scary. But it’s a normal part of stock market behavior that we have to accept along with the great historical returns that the stock market has enjoyed and that we are all expecting to receive as long-term investors.
So what can we do when markets are moving this much every day? Should we do anything at all?
The answer depends on where you are on the Pathway to FI: Trailhead, Ascent, Summit, or Descent. But there’s some common advice that we should all take as well.
Let’s take a look at what normal volatility looks like. Then we’ll dive into how to invest in a volatile stock market.
What is “normal” volatility for stocks?
For the rest of this article, I’ll consider the S&P 500 to be the “stock market”.
The average daily stock market move during the 90 years from 1928-2017 was ±0.73% according to this article. In that time, there were 12 years where the average daily move was greater than ±1%.
2022 was another one of those high volatility years. The average daily move in 2022 was ±1.2%. Almost half of the trading days had greater than 1% movement in one direction or the other. Although the market lost almost 19%, there were nearly as many days with 1% gains as there were with 1% losses.
From this data, I would call a 1% move in a single day relatively normal. Particularly in a year where there has already been a lot of volatility.
So we can expect to see plenty more ups and downs in the market. What does this mean for us as investors?
What to do if you’re at the Trailhead
At the Trailhead of the Pathway to FI, you may not have any stocks yet. Or they are still very small. But you are preparing to invest more soon, and seeing how much the stock market is moving every day—or the fact that it’s recently lost 10 or 20%—concerns you.
The best things you can do at this stage are:
- Stop watching financial news media – they always over-dramatize the markets and play with your emotions because that’s how they make money. Stay away!
- Stop looking at daily stock prices – you’re going to invest for decades, so individual days don’t matter. Focus on the long-term.
- Start educating yourself on the history of stock market returns instead – understanding stock performance through all of the crazy world and economic challenges will give you confidence to invest no matter what the market is doing.
Read How to Invest When Markets Are Going Down. It will give you some good perspective on the stock market. And it will help you understand that when you’re early in your investing career, lower prices in the stock market are a gift!
What to do if you’re on the Ascent
On the Ascent, you’re investing aggressively and piling as much money as you can into your portfolio. Volatility worries you a little more than those at the Trailhead, who don’t have much skin in the game yet. But it should be less concerning to you than those who are on the Descent of retirement and are now living off their assets.
If you’re watching financial media, watching daily stock prices, and haven’t educated yourself yet on the history of stock returns, do as I suggested for those at the Trailhead. Then take care of your current and future investments as follows.
Dollar-cost average
The great advantage that you have over a retired person is your income. Every time you’re paid, you can buy more stocks. This process is called dollar-cost averaging. It smooths your returns and makes it easier to stomach a wild ride in the market.
If the market has a bad week, you’re paying a lower price for new shares, and vice versa. If the volatility turns into a losing year, as it did in 2022, dollar-cost averaging loses less money than if the entire sum of money was invested at the beginning of the year.
The following plot demonstrates this. If you had $100k invested in the S&P 500 at the beginning of 2022 and added $1k at the beginning of each month, you would have ended the year with $91.7k out of a $112k investment. The same $112k invested at the beginning of 2022 would have gone through a wilder ride and ended the year $1.5k lower at $90.2k.
From a volatility standpoint, the portfolio in the dollar-cost averaging case ranges from a high of $101.6k to a low of $81.9k. That’s $19.7k in movement over the course of the year.
For the lump sum case, the portfolio ranges from $112.7 to $84.1k. That’s $28.6k from top to bottom during the year, or 45% more volatility than the dollar-cost averaging case!
That’s exactly why dollar-cost averaging makes it easier to ride out market volatility.
In a rising market, it works out better to have the entire lump sum invested at the beginning. But this isn’t an option for you anyway because you’re investing money as you earn it. So don’t worry about that. Just keep investing!
Stay invested
Dollar-cost averaging is a natural process when you’re paid every 2 weeks or so. But some people look at what’s happening in the market and decide to stop investing new money. Or worse, to pull all of their money out and wait for a “good time” to get back in. Neither of those decisions tends to work out. Research has shown that those who stay invested in volatile stock markets and just continue to dollar-cost average do better in the long-run.
The basic reasons for this are that the market generally goes up and none of us know the future. So it’s better to have your money invested for the eventual market recovery.
Investors who stop investing and pull their money out often get back in when the market has already recovered. Or they feel bad that they missed the bottom and never get back in!
One reason that timing the market is so hard is because the stock market is forward-looking, which means it’s trying to predict the future. By the time the good news that you were waiting for is here, the market is already at new highs.
If you’re not convinced that you should stay invested, look at the charts in this Morningstar article. You don’t want to miss out when the stock market rallies!
Stay aggressive, but consider a lower volatility, high return portfolio
You may be tempted to play some defense and tilt your portfolio to less volatile assets. Assets such as bonds or money markets may be less volatile, but they also have lower return over time. And that’s not what you want on the Ascent.
Instead of playing defense, consider this. Mixing an S&P 500 index fund with similarly volatile, high return, but uncorrelated asset classes such as Small Cap Value, International, REITs, or Utilities can improve returns and reduce the overall volatility of your portfolio.
There’s a lot of math behind how this works. But basically, the asset classes move up and down at different times. So when the S&P 500 is down, one or more of the other asset classes in your portfolio won’t be down as far. Ideally, they will be up instead. This is what happened with Utilities multiple times in 2022. And it’s why the Pathway to FI model portfolios has outperformed standard portfolios.
Read What Should My Asset Allocation Be for more on portfolio diversification and the Pathway to FI model portfolio that might be right for you. The white paper referenced in that article goes into much more detail on how the portfolios have historically achieved lower volatility and higher returns. Past performance does not guarantee future results, but it’s the best information we have to work with.
What to do if you’re at the Summit
At the Summit of financial independence, you can shift to a less aggressive portfolio to protect the wealth you’ve built. So the difference with how you might handle volatility between Ascent and Summit is mostly about how your portfolio looks.
The Pathway to FI model portfolios suggest moving about 20% of stocks into gold and long-term bonds at this stage. These assets are less correlated with the stock market than the assets that someone on the Ascent would hold. And therefore, they’re more likely to be up when stocks are down.
The Summit portfolio is about 25% less volatile than the stock market at the expense of slightly lower long-term returns. This is a good tradeoff that gives peace of mind to someone who already has all the wealth they need in life.
What to do if you’re on the Descent
On the Descent from financial independence into retirement, you no longer have an income to smooth the ride. You’re relying on investments to provide the money you need to live on. So volatility in your investments can be particularly stressful.
As with the other stages, you don’t want to be watching your investments on a daily, weekly, or monthly basis. Checking in quarterly or annually is all you need, so you can rebalance your portfolio and pay yourself.
A low volatility, high safe withdrawal rate portfolio works best
Some mainstream advisors recommend having large cash buckets of 2, 3, or even 5 years of expenses. That would reduce volatility in your portfolio. But anything more than 10% in cash (about 2.5 years) really hurts your ability to live off your investments for more than 30 years. And with people living longer and longer these days, you don’t want to take that chance.
The Descent portfolio puts 30% in long-term bonds and gold to make it about 30% less volatile than the stock market. And it has a high safe withdrawal rate that has lasted for 40+ years in the worst of times historically.
It’s 5% more volatile than a standard 60/40 stock/bond portfolio. But it has about 2% better returns and safe withdrawal rate. Perhaps most importantly, it hasn’t dropped as far and has recovered faster during stock market downturns.
This is the portfolio I’m modeling mine after for as long as I live—hopefully another 60+ years! And I’m confident it will last forever with a conservative withdrawal rate. If it does as well during the next 5 years as it has in other difficult periods in stock market history, I’ll be able to ramp up income in my 50s and beyond.
Don’t forget pensions and annuities
Employer and government pensions such as Social Security are great for reducing volatility in your finances. The payments are even and consistent. They work the same way as an income works for people at the Summit. They’re usually smaller than a full-time income, though.
Social Security has its challenges, but it isn’t going away. Benefits are likely to be reduced by 20-30% over the next few decades. If I only assume 70% of the benefit it currently promises my wife and me, it will still help substantially with volatility later in life. And it’s the only guaranteed income that increases with inflation. So don’t count it out entirely.
If you’re in your 60s or above, are still not confident that your portfolio will last, and can’t handle the volatility, there’s one more option to consider. An immediate annuity.
I used to be against annuities of any kind; but I’ve learned a lot more about them recently. I’ve read research from Dr. Wade Pfau and learned about his Safety First retirement income strategy. And I’ve come to understand the merits of immediate and deferred annuities as a form of longevity insurance.
I still recommend staying away from high cost fixed and variable annuities. Anything with an investment component tied to it is unnecessary and less valuable than investing directly in index funds. But having an annuity in your 70s or 80s is worth considering if your basic living expenses aren’t already covered by a pension or social security. It can cover the rest of your basic expenses, provide peace of mind from market volatility, and ensure that your money won’t run out if you live into your 90s or 100s.
Annuities look more attractive as interest rates rise. But they aren’t adjusted for inflation. So make sure you understand how much you need. And keep enough of your investments in assets that beat inflation in the long-run. Annuities should only make up a small portion of your portfolio.
Talk to a fee-only financial advisor or coach, not a salesman, to see if an annuity is right for you.
Consider earning some income
If none of the other solutions are enough for you, you can do some part-time work and smooth the volatility that way. Shift from the Descent back to the Summit and find work you can still enjoy. There are part-time jobs in your community that you might find interesting. Or you could do some consulting in your previous career field.
Whatever you do shouldn’t make you feel like you “failed” at retirement. You’re simply adjusting and adapting as all retirees do. Life is full of unknowns, so we all need to be ready to adapt.
I’m not earning much income from Pathway to FI yet. But I hope that will be an option in the future if it’s something that will give me peace of mind. Simultaneously, it will help me recognize that I’m providing value to my readers and clients. Another option for me could be working at a local outdoor outfitter, where I can work with like-minded people, learn more about hobbies I love, and help others learn to love them to.
Summary
Investing in a volatile stock market can be scary, especially when the general direction is down. But volatility is a normal part of investing. And you can limit its effect on your life and money by doing (or not doing) the things mentioned in this article.
What you do and what your portfolio looks like depends where you are on the Pathway to FI.
At the Trailhead, or at any stage:
- Stop watching financial news media
- Stop looking at daily stock prices
- Start educating yourself on the history of stock market returns instead
On the Ascent:
- Dollar-cost average
- Stay invested (applies at any stage)
- Stay aggressive, but consider a lower volatility, high return portfolio
At the Summit:
- Have a less aggressive portfolio to protect the wealth you’ve built
On the Descent:
- Have a low volatility, high safe withdrawal rate portfolio
- Don’t forget pensions and annuities
- Consider earning some income
These are general ideas that I hope will help you to manage your emotions and finances through volatile markets. Your specific plan and portfolio is up to you and your advisors. Contact me if you would like one-on-one coaching to help you navigate the emotions of investing and make good decisions.
To help manage emotions during stock market turmoil, read How to Invest When the Market Is Going Down or How to Make a Great Investment Policy Statement next.
And don’t forget to sign up for FREE at the bottom of the page to get much more value from PathwayToFI.
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