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Three Ways to Make Friends with Volatility

February 23, 2017

Investors are facing a harsh environment as we move further into 2017 with a new presidential administration and international turmoil. Warren Buffet was quoted as saying that “volatility is a long-term investors’ best friend” and I heartily agree. Volatility in markets produces anxiety but there is no escaping risk in investing.

Advisors and asset managers sometimes forget that the capital markets were not invented to provide returns for their clients. The markets were created to provide business and entrepreneurs with capital, while at the same time allowing them to offload the risk of the venture onto the backs of investors. The investor gets the risk, the transaction costs, and the tax bill – and maybe, just maybe, they get a positive return.

Below are three ideas on how to make friends with volatility.

1. Create a rebalancing plan and stick to it. One key to investing is to buy low and sell high, which can be very challenging when you don’t know how future prices will evolve. In a diversified portfolio it’s often useful to set a specific rebalancing target. For example, “if my weight to equity drifts to above 70%, I will rebalance back to my 60% target weight.” These kinds of rules can help you maintain a stable risk stance and also may help you create a contrarian trading pattern, so that during a boom you sell high and during a crisis you buy low. Market timing is difficult to get right but rebalancing makes a lot of sense at many different levels — for allocations between securities, funds, managers, sectors, countries, or even asset classes. Of course, rebalancing may not make sense in the context of an ‘emergency cash reserve’ — if the markets are down, using your cash cushion to buy equities may create too much balance sheet risk. However, if the assets are meant to be long-term investment assets, and the risk appetite is there, rebalancing can help manage risk and use volatility to generate extra portfolio growth.

2. Sell options. If you have been having trouble making friends with market volatility lately, you may be tempted to buy some downside protection, perhaps by buying put options to provide a floor on potential losses. Unfortunately, options have historically traded at a premium to the fair price implied by volatility, which means you would be overpaying for the insurance protection. For example, for S&P 500 Index options, the implied volatility calculated using the VIX index is 4.3% higher than the realized volatility on average from 1990 to 2016 (the premium is positive about 85% of the time). Said another way, the option market tends to overestimate future volatility, which translates directly into higher prices for both put and call options. For people interested in making friends with volatility (and have an appetite for taking these types of risks), selling options is a direct way to profit from market volatility. The best approaches are ones where the options are ‘covered’ by an underlying asset. For example, any S&P 500 index call options that are sold should be covered by an investment in the S&P 500 — so that if the market does rise rapidly, losses in the option contract are offset to some degree by the gains in the underlying security. Similarly for put options, holding cash or Treasury bills ensures the ability to pay out on the option contract should a crisis occur and losses on the options mount. Like any insurance provider, careful thought needs to be done to ensure the portfolio can survive the next disaster. For those providers that make it through, profit potential is increased.

3. Harvest tax losses. The tax code provides investors with a different kind of option: whether to pay their taxes now or later. If a security is sold at a gain it will be taxed. Instead, if the security is held, the taxes are deferred. It is common practice to harvest tax losses at the end of the calendar year to attempt to offset realized capital gains. However, this process can be systematized. For example, for an S&P 500 portfolio, which holds individual securities in a separate account, stocks that happen to be at a loss at some point during the year can be sold and replaced with similar stocks. In 2015, the S&P 500 was up 1.38%, but over 266 names showed a loss for the year. Even more stocks were at a loss mid-way through January of 2015. Even with a small active risk budget, say 1% tracking risk versus the market index, a tax-managed portfolio of stocks can produce 1% to 2% excess after-tax returns — even more in down markets.

People worry about the markets but no one knows whether they will go up or down in the coming days, months, or even years. In the longer term, the markets have provided significant returns for investors willing to take risks. Successful investors will be those with long-term mindsets that find ways to make friends with volatility.