My plan to navigate this market volatility

I wrote last week how the lack of liquidity can turn a conservative investment into a speculative one. This week every stock became speculative as the S&P 500 fell -4.99% as liquidity all but disappeared. The media has reported on a number of reasons why markets have suddenly become so volatile. I place the blame squarely on Wall Street’s financial engineering. Over the last few years, investment companies have created exchange-traded funds (ETFs) that leverage volatility. I warned about these ETFs a few years ago. At that time, I wrote that one day back in 2008, a marketing guy at Barclays got the idea that one way to hedge a portfolio was to buy volatility. The idea goes like this: bad news + volatility = stock losses. If we can financially engineer a product that tracks volatility, investors will have an instrument that hedges losses in their portfolio. This idea ranks up there right next to packaging subprime loans as one of the worst ideas ever. There has probably been more money lost on these volatility ETFs than investors who speculated on mortgages. It is so bad that Fidelity is now blocking investors from placing these trades in their accounts because so many customers are blowing up their portfolios.

An inverse volatility ETF helped to exacerbate this massive market sell-off. This product goes up in value as volatility decreases. At the bottom of this post, I added a chart of this ETF, which shows a loss of a staggering 90% in one day.  Rising interest rates added to the extreme volatility as investors now fear that higher inflation will stall economic growth. Interest rates are starting to rise because the economy is growing at its fastest pace in years.  This short-term pullback could be healthy for markets as the froth of the markets has been removed and investors are able to readjust their portfolios. This is exactly what I have been doing over the last few weeks with my client portfolios.

A very successful portfolio manager once told me that you need to take advantage of these sell-offs to upgrade your portfolio. While my investment strategy has not changed, I have changed my trading tactics to reduce risk in my client’s portfolio.  Here is my plan to navigate this market volatility and search for opportunities:

Maintain a higher allocation to cash. Investors have a tendency to become fearful by listening to market forecasters telling them that the stock market is going to crash. I believe you need a little extra cash to buy into this fear.

Dollar cost average into the investments that I believe offer higher return potential or offer more diversification.

Since all investments are getting crushed, I am sifting through and researching for the most undervalued companies or ETFs with the highest return potential. In market sell-offs, investors do not focus on market fundamentals. Instead, they become fearful as they gape at the wild price gyrations and focus on how many points the Dow Jones Industrial Average is falling.

This plan going forward will help to reduce risk and will put me more on the offense to take advantage of lower prices. I strongly believe that this market volatility is just noise.  The fundamentals and earnings projections for most U.S. companies has not changed. Volatility should never be directly related with risk. Volatility helps to readjust prices to their proper valuations. We all were waiting for this sell-off after 12 months of straight gains. It’s safe to say that stock valuations were slightly overvalued. The creme will eventually rise back to the top. The companies that successfully grow revenues, earnings, and cash flows, will be the ones that rebound the fastest after this sell-off ends.  I surmise that markets will remain volatile for the foreseeable future. It is impossible to predict when this correction will end or if interest rates will rise or fall. Nobody can successfully time the market. Instead, I will follow the above three strategies to navigate this new volatile market environment.

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