Making Money from Volatility (WSJ)

Playing The Market Plunge
The Return of Volatility Has Investors on Edge. Here's What to Do Next
By JEFF D. OPDYKE, JANE J. KIM, ELEANOR LAISE and LAURA SAUNDERS

Lest anyone had thought the rally of the past 14 months had restored calm to the stock market, Thursday's trading action was a reminder that the investing game is as dicey as ever.

During one brief afternoon spasm in which the Dow Jones Industrial Average plunged nearly 1,000 points, happy assumptions about the markets' solid footing and the U.S. economy's enduring recovery were wiped away. More selling on Friday reinforced the growing sense of unease.


"People had been thinking, 'Oh, that [global financial crisis] thing; I'm glad that's over,' and we're back to the races again," says Rob Arnott, chairman of Research Affiliates, a Newport Beach, Calif., investment firm. "But when expectations are that everything is fine again, a bolt from the blue can come from anywhere to send this market lower very quickly. It's a wake-up call that risk remains in the system."

Most unsettling was the apparent lack of an explanation for Thursday's violent swing. With the Greek debt crisis as a backdrop, some pointed to glitches in computer-trading programs. But upsets in a mechanism as complex as the global financial markets have no simple causes. Regulators and economists are poring over the trading tape in search of an answer.

It wasn't only individual stocks that were whipsawed. Several exchange-traded funds—portfolios that are listed on stock exchanges—traded at zero for a spell on Thursday. One, Vanguard Industrials, a basket of 372 stocks, fell from $54.66 to zero at 2:46 pm, then shot back up around $40 by 2:48 pm, then crashed right back down to 20 cents at 2:54 pm, then leaped back up by $54 by 3:06 pm.

The good news was that many of the trades that took place during those perilous few minutes are being canceled. The bad news is that the Dow still lost 5.7% for the week, its worst performance since March 2009.

Greece has investors the world over fretting that an economic contagion will sweep through Europe, which could, in turn, undermine major U.S. companies that sell into the European market. And although the U.S. economy is looking a bit healthier these days, fund managers say analysts' earnings estimates for U.S. companies are inflated by unrealistic profit-margin expectations; if earnings later this year start to arrive lighter than expected, the stock market could again see a sell off.


This week's instability and the possibility of more troubles have prompted investors like Maureen Green to rethink their portfolios. The 62-year-old retired nurse in Sarasota, Fla., estimates she lost about $40,000 on Thursday and is now planning to sell a chunk of her stocks. She says that until this week she had considered herself an aggressive investor, with 65% to 75% of her investments in stocks. Now, she's planning to bring that equity allocation closer to 55%.

"After having gone through the last two years," Ms. Green says, "there was such a lump in my stomach. It's too scary, especially when you're retired and this is what you're living on."

At times like these it is important to remember that the soundest investment strategies are built on level-headed stability and long-term execution. Not only can periods of high volatility be tamed—they can even create opportunities for profits.

Investors concerned with safety needn't flee stocks entirely to tone down their portfolio's risk. Lou Stanasolovich, president and chief executive of Legend Financial Advisors in Pittsburgh, offers clients several low-volatility portfolios that combine bond holdings with stock-focused funds that can also trade options or sell stocks short. Shorting involves selling borrowed shares in the hopes of buying them back later at a lower price.

Legend's most conservative portfolio, designed to have less volatility than an intermediate bond fund, has a 75% bond allocation. But it also includes mutual funds like Hussman Strategic Growth, which can use options and index futures to reduce exposure to market swings, and Caldwell & Orkin Market Opportunity, which uses short-selling and other strategies to neutralize the negative impacts of falling stock prices.

Investors who simply want to insure against a big market tumble can buy "put" options that rise in value as a broad-market index like the S&P 500 declines because they allow the owner to sell the index at a higher level.

Another options strategy that can help tamp down volatility: covered-call writing, which involves selling call options on stocks you already hold. (Selling a call obligates you to sell the shares at a predetermined price on or before a predetermined date.) The "premium" you receive—the price of the option that the buyer pays to you—tends to rise along with market volatility, and that income can provide some buffer against modest stock declines. In market rallies, however, this strategy lags because, amid soaring prices, stocks get called away by the buyer of the call options.

People who don't want to dabble directly in options trading can pursue this strategy through a fund such as the PowerShares S&P 500 BuyWrite ETF.
Investors seeking insulation from the market's ups and downs might also consider a counterintuitive step: buying direct exposure to market volatility. The iPath S&P 500 VIX Short-Term Futures exchange-traded note, for example, seeks to mimic the Chicago Board Options Exchange Volatility Index, or VIX.

Since volatility spikes tend to coincide with stock-market crashes, such an investment should zig when stock holdings zag and provide "a way to smooth out the entire portfolio," says Paul Justice, associate director of ETF research at investment-research firm Morningstar Inc.
Matthew Tuttle, a financial adviser in White Plains, N.Y., actually made money on one of his portfolios during Thursday's wild ride. He had a 15% position in the iPath exchange-traded note. That position, which gained 12% on Thursday, helped Tuttle's portfolio—which also holds gold and is short Treasurys—eke out a 1% gain for the day.

"Initially, when we put the trade on, it was a protection strategy," says Mr. Tuttle, who added the VXX in March. But he says he's also been able to profit from the position, which is up 31% since he bought it.

People can also invest in "bear market" funds, which aim to move in the opposite direction from specific market indexes. Though these funds do well in down markets, "their long-term returns haven't been very good,' says Russel Kinnel, director of fund research at Morningstar. ProFunds' UltraBear ProFund, for example, posted total returns of 65% in 2008, lost 52% last year and is down about 7% so far this year.
Meanwhile, so-called long-short, market neutral and absolute-return mutual funds, which follow hedge-fund strategies in hopes of generating returns in any market environment, can help pare losses in a down market, but often lag during a bull run.

A market plunge is also a good opportunity for investors to evaluate their diversification strategies. Diversification isn't only about owning a broad mix of drug stocks, retailers and energy companies. The practice takes many forms—across asset types, time and credit profiles, among others.

Over the last decade, even a strategy as simple as holding 60% stocks and 40% bonds beat the Standard & Poor's 500-stock index by more than six percentage points, and with far less risk. Over long periods, owning exposure to multiple types of assets, from stocks, bonds and cash to alternative assets like real estate, gold and commodities, can smooth the ride and boost returns.

In shorter time periods, diversification is less of a cure-all. An extreme downdraft can pull many asset classes down at once. During the financial crisis, notes financial planner Dean Barber in Lenexa, Kan., 38 of 41 asset classes declined at once—everything but cash, gold, and short-term Treasurys. So investors should be mindful of their time horizon: the sooner they need their money, the more of it should be in cash.
The strategy known as dollar-cost averaging is an easy way to diversify away the risk of time: by buying stocks in regular intervals rather than all at once, investors can lower the risk that they're jumping in at a short-term market top.

Grant Gardner, research director at Russell Investments, recommends investors also diversify across credit risks. How sound, for instance, is the insurance company that sells an annuity, or the municipality backing your local-government bonds? Concentrating too many of your assets in a single financial-services company can expose a portfolio to the risk that a major upheaval disrupts that firm's operations.

Finally, investors should marshal their cash smartly. For a decade or more, Wall Street's financial-planning machinery has claimed to have optimized the investing equation and boiled it down to simple calculations encouraging investors to abide by asset-allocation models heavy reliant on stocks, bonds and alternative assets. Cash was generally limited to a small fraction of an overall portfolio.

Yet cash serves a useful purpose, even if it earns paltry yields. It's emotional ballast.
In moments of unexpected market convulsions, low-cash portfolios are more painful both financially and psychologically. During Thursday's meltdown, for example, Christopher Schons, an aviation-policy analyst in Arlington, Va., watched nearly 10% of his family's wealth vanish on paper in just minutes. "I felt like I was in a Dali painting," he says.

Mutual-fund firm Invesco takes a "barbell" approach in its Charter Fund that is easily applicable to individual investor portfolios: 80% to 85% of its assets in investments on one side and 15% to 20% in cash on the other.

"Cash doesn't have market risk," says Ron Sloan, chief investment officer of Invesco's U.S. core equities group. "Don't be afraid to leave money on the table for your own sleeping comfort."

—Jason Zweig contributed to this article.
Write to Jeff D. Opdyke at jeff.opdyke@wsj.com, Jane J. Kim at jane.kim@wsj.com, Eleanor Laise at eleanor.laise@wsj.com and Laura Saunders at laura.saunders@wsj.com

Printed in The Wall Street Journal, page B7