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Increased volatility for markets in 2013?

There has been a fair amount of discussion in the investment industry recently regarding the potential for increased market volatility in 2013.

One recent article discussed a mathematical model that implies there is a high potential for an increase in volatility.

What may cause this increased market volatility? We think: increased investor focus on the debt ceiling debate, which will come more into focus in late February. The U.S. federal debt ceiling needs to be raised again to accommodate additional debt issuance by the U.S. Treasury in March. We think the tone and nature of the debate over the next couple of months could get quite ugly and increase investor anxiety, which could lead to rising market volatility (meaning “downside”).

One widely used indicator that market analysts watch to gauge market volatility is the VIX index. VIX stands for “CBOE Volatility Index.” The VIX measures expectations of near-term market volatility reflected in changes in forward stock index option prices. It is sometimes referred to as the market “fear” index. Large increases in the VIX index have tended to be associated with declines or corrections in the market.

Over the past several years, major spikes in the VIX have occurred following periods of 8-12 months of low volatility or quiescence in the index. We have been in one of these “quiescent” periods for the past 12 months. If history is any guide, the odds of a major increase in volatility may be rising.

So what does this all mean for financial planning and investing? As financial planners, there are things we can do to protect client assets from increased market volatility. One of the ways is through diversifying investment holdings by asset class. This reduces portfolio volatility because different asset classes behave differently in varying market conditions.

Another way to reduce volatility is by holding larger proportions of dividend-paying stocks, as they tend to be less sensitive to harsh swings in the market. A disciplined investment process or model can also help to keep investment decisions within rational bounds and help avoid the temptation to make emotionally based decisions.

Finally, having a sound financial plan that incorporates reasonable and reasoned spending, income and investment return assumptions is essential.

Bob Toomey is vice president of research for S.R. Schill & Associates, a registered investment advisor located on Mercer Island.

 

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