Market volatility like we’re seeing right now is unsettling, but it is a moment where investors can play both defense and offense in our portfolios.
- Defense:
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- Broad diversification limits the exposure of portfolios to any one asset class. The current bout of volatility is a classic example of why we recommend broad diversification, and anyone who has followed the strategy is likely sitting much better than someone only invested in the S&P 500 so far this year.
- Offense:
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- Tax-loss harvesting strategies can create benefits for investors who don’t currently take advantage. Volatility helps create opportunities for these strategies.
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- For investors facing large capital gains – from concentrated positions, real estate and business sales, or private equity distributions – using a long-short strategy magnifies the effect of tax-loss harvesting, creating opportunities to help reduce or even offset tax obligations.
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- Prices of equity options generally go up with higher levels of stock volatility, possibly creating improved economics from options strategies like covered call writing.
The stock market has had a volatile start to the year, as we saw this past week when the S&P 500 briefly entered correction territory. But as we discussed in the most recent Market Perspectives podcast, and will summarize here, when markets become volatile, investors can do more than survive – for many, there may be opportunities to take advantage of that volatility.
A primer on volatility
We can see volatility by looking at the gyrations in the S&P 500, of course. Many investors also closely watch the CBOE’s Volatility Index known as the VIX, which measures market expectations of volatility over the next 30 days. So far in March, the VIX has been at an elevated level compared to almost all of 2023 and 2024.
Now, not all stock market corrections turn into bear markets – out of 56 corrections since 1929, only 22 turned into a bear market that experienced a decline of 20% or more.
A similar point is true about episodes of elevated volatility. While it’s true volatility spiked for the global financial crisis or the market panic early in the pandemic, it’s also spiked many times for events that ended up not having a lasting market impact.
Some episodes where volatility spiked but later calmed without leaving any sort of lasting damage to the U.S. stock market might include the 1998 collapse of the hedge fund Long-Term Capital Management, the Eurozone debt crisis in 2010 or the August 2015 flash crash when the Dow fell over 1,000 points in the first few minutes of trading.
If you were watching markets every day in those periods you likely remember the turmoil, but in hindsight, these were great years to own stocks. The S&P 500 climbed almost 29% in 1998, 15% in 2010 and after the several-minute plunge of the 2015 flash crash, the market climbed 10% the remainder of that year. The point here is that a bout of volatility, though it’s reasonable to be concerned about it, is a poor reason to get out of the market.
Diversification is the first line of defense
The recent bout of volatility has provided a potent reminder of why Mercer Advisors recommends that clients implement broadly diversified portfolios. While the S&P 500 briefly entered correction territory in March, emerging markets are up 7% year-to-date and developed markets ex-U.S. are up over 9% year-to-date. The Bloomberg U.S. Aggregate Bond Market Index is up over 2%.
It’s tempting for investors to see a hot asset class – think the Magnificent Seven tech stocks – and want to go all in on that class. From a behavioral finance perspective, we may have anchoring or overconfidence bias here as investors. We cling to the last 10 years of growth stock returns and think that will continue the next 10 years. But episodes like this remind us of the advantages of diversification. A broadly diversified portfolio limits our exposure to any one asset class during a period of underperformance.
Playing offense with tax-loss harvesting
We can do more than play defense during periods of market volatility, however. One strategy that many investors could be taking advantage of in moments of volatility is tax-loss harvesting.
Tax-loss harvesting involves closely monitoring portfolios to methodically sell investments that have declined in value and replacing them with an investment with very similar characteristics. This strategy seeks to track the market performance of a chosen index while generating tax losses along the way. Note: tax-loss harvesting strategies should always be carried out in accordance with the IRS Wash Sale rule.
For investors who are recognizing capital gains on an ongoing basis, a tax-loss harvesting strategy can be low-hanging fruit to help offset some of that tax obligation. During periods of volatility, more opportunities for tax-loss harvesting naturally occur.
Diversifying concentrated positions
We know that many investors come to Mercer Advisors for help managing concentrated positions in a single stock, often with a very low tax-basis. Volatility creates a significant opportunity for investors in this situation. (The following strategy can potentially help investors with large capital gains obligations from the sale of a business or real estate, as well.)
Long-short strategies are a popular solution for investors looking to diversify a concentrated position. Long-short strategies involve combining long investments with short selling. If the market goes up, the longs do well, and tax losses are generated on the short side. If the market goes down, the shorts do well, and tax losses are generated on the long side. For a deep dive into long-short strategies, listen to our Exploring The Long-Short Strategy podcast.
Market volatility creates opportunistic trading possibilities for the manager of these strategies. One risk of a long-short strategy is there can be too little volatility for the strategy to generate sufficient losses. That’s less of a concern right now!
Advanced strategies to consider
Some investors may be looking for even more advanced strategies, such as around options. Some options strategies have advantages in the current environment. Volatility generally increases option values (this is the Black-Scholes formula for finance students out there) and could benefit clients who engage in covered call writing strategies, for instance.
The key takeaway is simply that volatility, though unsettling, is something we plan for — and even something we can sometimes take advantage of.
Click here for past insights about the recent market volatility and other interesting topics. Not a Mercer Advisors client but interested in more information? Let’s talk.
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Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may materially alter the performance and results of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. Diversification does not ensure a profit or guarantee against loss. Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark.
