How to use a diversified portfolio to navigate bouts of market volatility

The recent sharp in volatility, as evidenced by the recent spike in the (VIX), is a reminder that market fluctuations are an inherent part of investing, Wells Fargo strategists noted in a recent report.

However, the investment bank advises against reacting hastily to these fluctuations by reducing equity exposure, stressing the importance of sticking to a well-diversified asset allocation.

In a nutshell, strategists argue that volatility should not drive investors to exit the market or attempt to time it.

They highlight that volatility is not solely associated with downturns; sharp upswings can also occur, often in close proximity to downturns. The note underscores that missing just a few of the market’s best days, which often coincide with periods of elevated volatility, can significantly reduce long-term returns.

“Additionally, over the past 30 years, two of the three most recent bear markets comprised almost all of the worst 20 days and half of the 20 best days, further illustrating that the market’s best days often come when volatility is at its highest,” the report states.

Moreover, the most significant market gains and losses frequently occur in quick succession, especially during periods of heightened volatility linked to economic recessions or bear markets. For instance, between March 9 and March 18, 2020, the market experienced two of its best days and four of its worst days within just eight trading sessions.

Wells Fargo further details the psychological biases that may influence investment decisions during volatile periods.

Biases such as loss aversion, herd behavior, and overconfidence can lead to detrimental actions like panic selling or excessive trading. The strategists stress the importance of maintaining discipline and not allowing short-term market movements to derail long-term investment strategies.

Strategists believe that both tactical and strategic investors can benefit from a diversified portfolio that includes various asset classes with different levels of correlation.

For tactical investors, the note recommends taking advantage of market dislocations by making tactical shifts—reducing exposure to areas expected to underperform and increasing exposure to those better positioned to weather volatility.

For longer-term, strategic investors, the key takeaway is the resilience of markets over time. The stock market has historically rebounded from significant downturns, often moving to new highs.

“For the long-term investor, time is on their side to potentially recover from these downturns if they remain disciplined,” strategists continued.

“In our view, both tactical and strategic investors can benefit by utilizing a diversified allocation that includes a selection of asset classes with varying degrees of correlation to one another.”

In addition, implementing a regular rebalancing strategy helps ensure that the portfolio remains aligned with the investor’s objectives and maintains the desired asset allocation.