This year started out the worst on record for U.S. equities. However, since the declines in January and February, markets have recovered quite nicely. Today all major asset classes with the exception of some international markets have posted positive returns.
Yet now, with the U.S. Presidential election just more than a week away, investors are increasingly worried that volatility could return with a vengeance. The groundwork for that market rollercoaster seemed to be provided on Friday with news of the “October Surprise” that the Federal Bureau of Investigation (FBI) would review new evidence in the investigation of Democratic presidential candidate Hillary Clinton’s email server.
Following that revelation, the CBOE Volatility Index, or VIX, a measure of traders’ expectations for market swings, climbed 5.4 percent. The uptick likely reflects concerns about two potentially market-moving events–the U.S. presidential election and the decision by the Federal Reserve (Fed) on whether to increase interest rates. The Fed has signaled that a rate increase is planned for December. However, the Presidential Election results may impact that decision.
With volatility possibly coming back into the picture, I want to emphasize that there are important upsides to volatility. Importantly, rocky markets do not mean it’s time to dump stocks. It’s essential to understand the “risk premium.” Yes, stocks are more volatile than bonds in the short term, but that is precisely what enables stocks to deliver higher returns over time. And long-term investors need the growth afforded by equites to defend against inflation and support retirements that could span decades.
For this same group of long-term investors, periodic downturns can be viewed more positively as buying opportunities. When a stock’s price plummets, you can buy shares at a discount. Then, as the market recovers, your portfolio’s overall return benefits from a little extra boost.
Finally, as tax time draws near, portfolio declines offer the opportunity for aggressive tax loss harvesting. When you sell investments at a loss, you can use those losses to offset capital gains elsewhere in your portfolio. If additional losses remain after you have offset all portfolio gains, you can use losses to offset up to $3,000 of your ordinary income. Note this delivers additional tax savings because your income is generally taxed at a higher rate than your capital gains. And, if you have losses remaining after offsetting the $3,000, you can carry them over to offset capital gains in future tax years. Talk about using lemons to make lemonade.
There’s no question that any significant stock market plunge is scary. However, it’s important to view any decline as a short-term hardship and maintain your investment discipline and long-term perspective. As we saw post-Brexit, markets tend to decline on news of extreme events and bounce back according to solid fundamentals. It is wise to brace yourself for volatility to guard against emotional reactions. However, don’t forget that in the long-term volatility can be an important positive driver of portfolio returns.