Embracing Volatility – How to Buy Low and Sell High

It was not even a month ago that I wrote a 2022 Investment Outlook predicting there was some volatility coming our way, and following the US Federal Reserve’s commitment to tackle inflation, the markets did not disappoint. The S&P 500 is down some 10% from its peak, the NASDAQ 15%, and Bitcoin, being Bitcoin, dumped over 50% in a matter of weeks. Welcome to 2022!

The last time I heard the term “indiscriminate selling” was March 2020, as stock markets were actually being closed early for falling to their limits for several days running. Risk happened fast as investors dumped everything: stocks, bonds, gold, crypto, you name it. Everything went to cash. There wasn’t a lot of thinking going on, just a mad rush for the exits.

We haven’t reached that level of panic so far this year, but in the US the steady pulse of easy monetary policy is fading, and as I write this the Nikkei 225 index is down over 3% on the day. There is clearly more volatility to come. So how do you invest in this environment? Selling indiscriminately along with the herd is clearly not the smart way.

As usual the strategy needs to be broken down into core and satellite. The core being the 70-80% of your portfolio that is broadly diversified, and satellite being the 20-30% you may have in something a little more sexy.

Core holdings – I have already written about how to buy low and sell high in your core allocation here. In short, you establish a strategic asset allocation that meets your risk profile and then rebalance it once per year. The rebalance in effect sells part of holdings that have gone up in value and reallocates them to the holdings that have gone down. That’s it, no further action required!

Satellite Holdings – Now for the fun part. Satellite holdings are generally invested in assets that add a little more spice to your overall portfolio. They usually have a higher risk / return profile and may change over time depending on market conditions and what is hot. So they could include an allocation to smaller companies, emerging markets, emerging technology, commodities, private equity, and of course crypto. I would note here that for someone who is retired, satellite holdings may actually be lower risk, alternative income-focussed assets, but for today we are talking about the racy stuff!

Higher risk plays tend to exhibit bigger swings, and are therefore more tempting to try and time the entry / exit. So, the first thing you need to do is make an honest assessment of your temperament and ability to manage more risk. I’m no trader and I know it, but I do have the stomach for volatility for part of my portfolio.

Scale in / Scale out: The simplest way to buy something volatile is a little at a time. Dollar cost averaging is probably the most effective way to do this. Buy a little every week, every month, or every quarter until you build your position into the size you want. As you get better at this you will learn to add a little more in months when the asset is cheap, and a little less when it is more expensive. Looking back at the chart above, it’s clear that the panic of March 2020 was a golden opportunity to acquire risk assets, but it takes some guts to be buying when everyone else is selling. That said, buying the asset is generally easier than selling it, and you don’t make money until you sell! Waiting for that perfect top is a recipe for disaster for all but the best market-timers. You need to set yourself a target price, and be prepared to adjust it if conditions change. Once you reach your target, sell half. If you think it might have more to run, don’t get too carried away. Average back out of the asset little by little, the same way you got in. You may end up feeling like you left some money on the table, but that money doesn’t exist if you go over the precipice and tumble down the other side.

If the asset is traded on an open market, learn how to set a stop loss. If it’s trading above your target price and you have already sold half, you can set the stop loss at your target price to make sure you get out if the market takes a turn.

All of this sounds great in practice, but I have personally screwed up trying to time markets more often than I have got it right. This is why position size is important. If you are in something volatile like bitcoin, which frequently dumps 50% just when you think it’s going to the moon, you are going to get it wrong sometimes. You shouldn’t have half your net worth in there! I would also say that you should be invested in assets that, although they may be hot at the moment, you don’t mind holding for the next 10 years. It takes a lot of pressure off if you get stuck in something you understand and believe in during a bear market.

Cutting your losers quickly is good advice, but many people struggle with it as they get attached to the trade and don’t want to lose money. If it’s an asset you believe has great long term prospects, then you can ride out a few bumps in the road, but if the fundamentals change and you realise you were wrong, it’s time to take the hit. Psychologically, people are conditioned to try to be right all the time, but it simply isn’t possible in investing. Accept that you will be wrong sometimes and move on.

Experience is, of course, the best teacher. Keep your positions small enough that you can learn from your mistakes without blowing up your balance sheet. Keep an eye on what smart people are doing, but make your own assessment before entering something risky. One thing you can be sure of: taking a little risk helps you to get to know yourself better!

Disclaimer: This should go without saying, but the information contained in this blog is not investment advice, or an incentive to invest, and should not be considered as such. This is for information only.

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