Note: this post on managing market volatility is more related to general trading than commodity specifically.
Managing market volatility is tough even without having to deal with unpredictable price direction. With a little bit of planning you can make managing a portfolio easier by being prepared for any volatility that may come your way.
What is Volatility?
Technically speaking, volatility is a measure of variation of prices over a certain period of time. What this means is that when market prices are moving quickly in one direction the volatility is usually increasing (For options traders, the volatility is usually higher on moves to the downside in equities and higher to the upside in commodities because of the vol skew and the preference of writing calls or puts, but that is for a different post).
What exactly causes market volatility is usually different, but it is always some sort of unexpected event or news that causes the market to reconsider its expectations. This reconsideration of expectations is usually an emotional event that occurs relatively quickly as investors try to evaluate what the new fair value is.
When the markets are moving quickly and the volatility is increasing it can be quite emotional for investors who could see large amounts of their investments disappear relatively quickly. Luckily, there are a few proven strategies that will help you manage volatile market conditions and keep your portfolio on the right track.
Diversify your Portfolio
Portfolios that are highly concentrated in similar assets tend to be exposed to higher levels of potential volatility. This doesn’t mean that having a large number of different commodities is risky, it means that having a large number of very similar positions can be risky. Take oil and gas commodities during the COVID-19 outbreak. When the COVID-19 outbreak occurred the country quickly went into lockdown and stopped traveling. This lack of travel reduced the demand for oil and gas, which caused the entire industry to decline. If your portfolio was weighted heavily towards the oil and gas sector as COVID-19 was breaking out your investments would have declined like the industry did.
In order to adjust for scenarios like the one above it is very important to own a number of commodities that vary in demand and production types. Doing so will make sure that your portfolio doesn’t rely too heavily on one individual type of commodities and will allow you to weather market volatility better than you otherwise would. For example, if the COVID-19 outbreak occurred and your portfolio was split with only 25% in oil and gas and the rest spread between grain, softs, metals, etc. you would have fared much better than only owning oil and gas positions.
Things to Consider:
- Does your portfolio weight very heavily towards one asset? If yes, you may way to reconsider whether you want your portfolio to contain so much single asset risk.
- Do your positions tend to be correlated to the same things? If yes, your portfolio may be less diversified than you expect and may require some rethinking.
Determine your Risk Profile
Another critical component to determining whether your portfolio can manage market volatility is to analyze and determine your individual risk profile. Put simply, can your financial and emotional state handle large variations in prices? Your individual risk profile will give you an idea of how much volatility you can withstand so that you can then determine how much of your portfolio should be allocated to stocks, bonds, and cash.
A portfolio that has a higher allocation in stocks is usually going to be one that has a higher potential return over the long run, but it is also going to be more volatile in the short run. This allocation, and your risk profile, also tends to vary with age. Generally, younger investors tend to be allocated more towards stocks because they have a longer investment horizon. On the other hand, people who are approaching retirement age should be allocated more towards bonds because their investment horizon is shorter and they are more likely to need to money relatively soon.
Things to Consider:
- Do you plan on needing your invested money soon? If yes, you should consider a lower risk profile and one with potentially more bonds and less stocks
- Are you ok with seeing 10% plus gyrations in your investments? If no, you should probably consider a lower risk profile and potentially one with more bonds and less stocks.
Take a Longer Market View
Volatility is often driven by uncertainty and uncertainty is often driven by emotion. That means that in many cases the extreme market fluctuations are being driven by an emotion such as fear or exuberance. Usually those emotions are going to be short lived, so if take a longer term view you are better able to weather the short term market gyrations.
Things to Consider:
- Do you plan on needing your invested money soon? If yes, then taking a longer term view might not be possible and you should potentially consider additional diversification
- The longest bear market in history was roughly 3 years. If you to put your investments into a 3 – 5 year time horizon you will almost always find a price outlook that is higher than it is today
Average Into Positions
It is almost impossible to consistently time the market which means that occasionally you will enter into a position and lose money shortly after as the price decreases. One way to manage market timing is to average into your position over the span of a few weeks, months, or years. Doing so will allow you to average out the times when you bought and prices decreased shortly after.
Things to Consider:
- Take your investment horizon into consideration. If you are investing for your retirement you are likely going to want to average into positions over the course of years. On the other hand, f you are investing for a shorter time frame you might consider averaging in over the course of a few weeks or months
- Don’t stop, stick to the plan! Whatever plan you decide, know that volatility will occur and you will occasionally buy near the top and near the bottom. Don’t get scared or over confident and change your plan.