How to Cope With Market Volatility

In August, the VIX spiked to 28.3, its highest level since 2011. Recently, it has levelled off to 24.8, which is still historically high. Another way of looking at volatility: The S&P 500 has risen an average of 0.02% a day since the start of 2000. Since August, it has fallen an average of 0.21% a day.

What's Behind the Volatility?

Worries about China's economy are a factor. Last week, the Chicago Purchasing Managers Index plunged to recessionary levels, with 30% of those polled saying that China's economic woes had a greater effect on them than Europe's problems. The PMI is a monthly poll of purchasing managers and is widely used as a leading economic indicator.

Another worry is the Federal Reserve, which may raise interest rates later this year. While the increase in the fed-funds rate would be small – just 0.25%, most likely – it could push the value of the dollar higher and put increased pressure on emerging-markets economies.

And then there's earnings. Markets get particularly jittery as big, bellwether companies report, and they sell off if there are big disappointments.

Finally, Congress will have another rendezvous with a US government shutdown on December 11, when the most recent continuing resolution for 2016 will run out of money; the federal budget year ends October 1.

But before you decide to sell all your stocks and move to Australia, or make any portfolio adjustment based on recent volatility, ask yourself these three questions:

Is My Risk Tolerance Really What I Thought It Was?

Investors often feel that they have a high risk tolerance when the markets are stable and rising. "Now it's time to review what your risk tolerance really is," says Michael Kitces, partner and director of research for Pinnacle Advisory Group in Columbia, Maryland. "Did you fool yourself into thinking you had more risk tolerance because you were underperceiving the risk?" If the market's volatility is truly terrifying you, then you need to readjust your portfolio to a level of stocks that will let you sleep at night.

When Will I Need My Money?

If you're investing for a retirement that will start in 10 or 20 years, then sharp intraday moves shouldn't concern you. Volatility reached a fever pitch in 2009, but selling your stocks then would have been a terrible idea. The S&P 500 has gained an average 17.05% a year since the market's bottom in 2009.

Is It Really That Bad?

Measured by the daily spread between high and low prices – yet another method for gauging volatility – the stock market is relatively calm, argues Howard Silverblatt, senior index analyst for S&P Dow Jones Indices. The S&P 500 was more volatile in nine of the past 15 years this century.

Nevertheless, it's nerve-wracking to discover that stocks tumbled more than 3% in a day, as the S&P 500 on two consecutive days in August. After all, the stock market often becomes more volatile before a major bear market.

The Effect of Volatility on Retirement Investors

If you're nearing retirement – or in retirement – then you have good reason to be nervous. Taking withdrawals in a bear market will draw down your account faster than you'd probably like. If the market falls 10% and you take a 4% withdrawal, your account will be down 14% – a clearly unsustainable rate. If you're nearing retirement, then a widely diversified portfolio is your best friend in a volatile market. You'll want cash on hand, both to cushion downturns and to use as a buying reserve when stocks are cheap.

You'll need bonds, too, because they rise in price when the economy looks soft. Unfortunately, their prices fall when interest rates rise. And at current levels, rates are more likely to rise than fall.

But that doesn't mean you should ditch bonds entirely, says Christine Benz, director of personal finance at Morningstar. "Even though bond prices could fall in certain scenarios, high-quality bonds will tend to hold up much better than stocks when investors are nervous about the economy. When stocks dropped in the third quarter of 2015, for example, high-quality bonds were a rare pocket of positive returns," she says. "Just be careful not to overdo it with lower-quality bond types. Their yields are higher than high-quality bonds, but they will tend to perform more like stocks than bonds."

If you're a retiree, having a cash cushion is probably your best response to increased volatility. You want a pool of money to tap when the stock market is on its worst behaviour. While money market funds yield an average of 0.02%, and even one-year savings accounts yield less than 1%, tiny returns are better than big losses.

"Having a cash cushion to meet near-term living expenses can provide valuable peace of mind in tough markets," Benz says.

“A cash buffer can also help you regroup if something derails your cash flow strategy; for example, many dividend-focused investors were scrambling when banks cut their dividends during the financial crisis. You don't want to go overboard, because cash is a losing proposition once inflation is factored in. Enough to cover six months to two years' worth of living expenses is plenty."

Volatility – at least if it's on the downside – is about as much fun as a kidney stone. And while it's the market's risk that also gives return, it's hard to think about that if you're nearing retirement or in it. While you should never sell out of panic, it always makes sense to readjust your portfolio according to your goals – and a newfound sense of what risk really means.

This article was written by John Waggoner, a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.