Five strategies to navigate market volatility

Investing in a stock market without volatility is as illusory as driving a car without an engine. Like it or not, the two concepts invariably go hand in hand. But does that mean you should avoid volatility and investing altogether?

The short answer is no. Market uncertainty can naturally cause panic and lead to poor investment decisions. Yet, by recognizing short-term market uncertainty for what it is, you can help ensure that it doesn’t derail your long-term goals.

Here are five tested principles that can help you gain needed perspective.

Investors generally feel a financial loss about two and a half times more than a gain of the same magnitude. Understandably, many of us experience a roller coaster of emotions when investing (see Figure 1), which can translate into impulsive buy and sell decisions.

Staying aware of these emotions during periods of increased volatility can help you avoid panic, keep calm and remain focused on reaching your long-term goals.

Source:  Darst, David M. (Morgan Stanley and Companies, Inc.). The Art of Asset Allocation, 2003.

Trying to time the ups and downs of the market is a bit like the roll of a dice. Consider the impact of missing the best 10, 20 and 30 days on the value of $10,000 invested in Canadian stocks over the past 10 years.

As Figure 2 shows, sitting on the sidelines can be costly. Over a 10-year period, if you’re out of the market for even a few days when the market is outperforming, you can substantially reduce your return potential.

Staying invested, while not always easy, can potentially translate into a better outcome.

Figure 2 - Source: Morningstar. For illustrative purposes only. S&P/TSX Composite Total Return Index, December 31, 2013 to December 31, 2023. It is not possible to invest directly in an index. Assumes reinvestment of all income and no transaction costs or taxes. Value of investment calculated using compounded daily returns. Missing 10, 20 and 30 best days excludes the top respective return days.

Risk can be a loaded term when it comes to investing and is often misunderstood. You often hear about risk and volatility in investment parlance, and while the two concepts are related, they are not the same.

Risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. On the other hand, volatility simply measures how much the return of an investment or the broader market fluctuates up and down. While some may fixate on these fluctuations, the permanent loss of capital should be of greater concern. Reducing exposure to securities that are perceived as ‘risky’ will certainly lower market risk. Still, by doing so, long-term investors could potentially see the purchasing power of their savings erode faster and outlive their savings quicker.

Whether we like it or not, risk and investing in the stock market are a package deal. The key to long-term success is managing your risk exposure by using time and diversification to your advantage.

Figure 3 demonstrates the calendar-year returns for a hypothetical All Equity and a Balanced Portfolio. It shows that while the performance of any portfolio can swing significantly each year, a Balanced Portfolio has historically resulted in fewer negative returns than an All Equity portfolio over the long term.

When you look at the performance of the same two portfolios over a 3-year period (Figure 4), the frequency of negative occurrences significantly declines, highlighting the positive impact of time in further reducing volatility.

Source: Morningstar. Returns are calculated in Canadian currency. Assumes reinvestment of all income and no transaction costs or taxes. The portfolios are for illustrative purposes only. It is not possible to invest directly in an index.
¹Based on the calendar year returns of the S&P/TSX Composite Total Return Index from 1960 to 2023.
²Based on 3-year annualized returns ending December 31 of the S&P/TSX Composite Total Return Index from 1960 to 2023.
³Based on the calendar year returns of a portfolio of 50% the S&P/TSX Composite Total Return Index and 50% Canadian Fixed Income Composite from 1960 to 2023.
⁴Based on 3-year annualized returns ending December 31 of a portfolio of 50% the S&P/TSX Composite Total Return Index and 50% Canadian Fixed Income Composite from 1960 to 2023.
Canadian Fixed Income Composite consists of 80% FTSE Canada LT Bond & 20% FTSE Canada Residential Mortgage Index from 1960 to 1979; 100% FTSE Canada Universe Bond Index from 1980 to 2023.
Best and worst year rates of return based on each time period specified.

Like the familiar adage, “Don’t put all your eggs in one basket,” diversification is a tried-and-tested technique that mixes different types of investments in a portfolio to lower risk. No single asset class is consistently among the top performers, and the best and worst performers can change from one year to the next.

By including investments that are less correlated to one another – or react differently to economic and market events – gains in some can help offset losses in others. As Figure 5 illustrates, a diversified portfolio with different asset classes provides the opportunity to participate in the potential gains of each year’s top winners while aiming to lessen the negative impact of those at the bottom.

Source: Morningstar. Priced in Canadian currency, as of December 31, 2023. Assumes reinvestment of all income and no transaction costs or taxes. Annual returns compounded monthly.
The asset classes are represented by their indicated indices, and the balanced portfolio is illustrative in nature and was rebalanced monthly. This information is for illustrative purposes only. It is not possible to invest directly in an index. Canadian Home Prices: Teranet-National Bank House Price Index Composite 11 index (C11). The calculation methodology for the Teranet-National House Price Index Composite has been adjusted effective December 19, 2023. Historical C11 index values have been recalculated to reflect this methodological change.

Dollar-cost averaging (DCA) is an investment method that helps reduce the risk of timing a lump-sum investment. By investing a fixed dollar amount regularly, the dollar-cost averaging process helps control the effect of market volatility by smoothing out the average cost per unit of mutual funds purchased. 

Over time, and in certain market conditions, it could result in a lower average cost and a higher return. Figure 6 illustrates how a dollar-cost-averaging strategy compares to a lump sum purchase in 2020, a period punctuated by extreme market volatility and a significant correction.

While it’s important to note that DCA doesn’t always produce a higher return versus lump sum investing, this systematic approach can help investors stay the course by taking the guesswork out of when to invest.

Source: Scotia Global Asset Management and Morningstar. Based on an illustrative investment in the S&P/TSX Composite Total Return Index. It is not possible to invest directly in an index.
¹ Dollar-Cost Averaging illustration assumes 12 contributions of $500/month made between January 1, 2020 and December 31, 2020, totalling $6,000 in contributions.
² Lump Sum illustration assumes a one-time $6,000 contribution was made on January 1, 2020. The year 2020 was used for illustrative purposes as the benefits of dollar-cost averaging were prominently demonstrated.

Short-term market ups and downs can cause even the most experienced investors to lose sight of the big picture. An advisor can help you develop a financial plan, recommend suitable investments and navigate rough waters. 

With the help of your advisor, understanding your initial reactions to market ups and downs can help you make better investment choices, view your portfolio more objectively, stay the course, and ultimately reach your goals.

What are Canadian investors who work with an advisor saying?¹

• 71% say their advisor helps them avoid making mistakes when buying and selling investments
• 78% say their advisor keeps them on track to meet their goals
• 63% say they are better off financially than if they managed their money on their own