eSignal - Smarter Trading Tools

Three tenets of stock market investing in volatile environments

June 21st, 2016

Stock market volatility is an ominous description. For good reason too. According to a USA Today report, the U.S. stock market showed signs of a slow down recently after the Dow Jones Industrial Average, Standard & Poor's 500 Index and Nasdaq Composite Index all dropped 0.7 percent, 0.9 percent and 1.3 percent, respectively. Naturally, some investors have begun to panic.

But the key now should be to prioritize strategy over stocks. The good news is that volatility is an opportunity to buy undervalued stocks. Your goal here should be to focus on dividends and growth. It is important to keep in mind, though, you are not buying stocks here to get rich quick. On the other hand, the bad news is that it is tough to see the light through the fog of doubt springing up from stock market analysts. There are emotional reactions filling the media, as they tend to do when market volatility creeps in as it has now. Needless to say, this can become distracting.

That is why, listed below, are three basic tenets of stock market investing strategy to use during volatile times like we are in now.

Know your risk tolerance or face the consequences
For some investors, finding this out involves trial and error. But that's the expressway to a very upset stomach. Just ask anyone who invested during the financial crash eight years ago. So how do you determine your risk profile?

Follow specific stocks you are interested in for a few weeks. If they fluctuate rapidly in prices, and you cannot stomach the thought, there is your risk tolerance. Another great way to alleviate any pain from risk tolerance is to diversify your stock portfolio among the large-cap, more blue-chip stocks. You may not profit right away, or if you do it may be incremental, but you most likely will not lose your investment. That is equally as important as gains now. Finally, a great way to beat the stress of risk is to sell off underperforming assets. At least you can cut your losses and recuperate part of your investment capital to re-allocate to more profitable stocks. For more information on your risk tolerance, stock market analyst has some insight into the matter:

Pay more for blue-chips and save more later
Higher quality stocks, particularly in periods of volatility, become even more valuable. They offer protection from downward pressure and losses. The price stability and consistent returns is more than a welcome consolation to big time gains.

You should look at the standard deviations of a stock to determine which ones fit this description. Lower standard deviations means more resilience to volatility, which is what you want. With these stocks, you want business models you can understand with strong balance sheets with large amounts of cash flow and no debt. Dividends are a given, especially companies that will increase them over time. But you also want a stock that has a history of spending funds in ways that benefit shareholders.

Look for values and diversify
Volatility puts blue-chip and higher quality stocks in positions of value. It is up to you to find them, so you can diversify your portfolio into new sectors. This is a key component of every stock investment strategy at any age and stage in life because you want to limit the risk of price declines.

Volatility puts blue-chip and higher quality stocks in positions of value.Periods of market stress create irrationalities that put higher quality stocks in positions of value.

This is important to note because the types of stocks that have performed well on various stock indexes have evolved in recent years. According to Seeking Alpha, the S&P 500 Index for example has seen its top performing sectors shift from telecommunications, energy and utilities stocks to tech, consumer products and industrial companies. All the time though, the S&P 500 Index has maintained its dividend yield at 2.13 percent each year since 1996.

So regardless of the index, it is important to look at the sector over the stock in most cases. This will help you to keep your portfolio performing well over time.

Stick to your guns
These tips may sound easier said than done. But even savvy investors fall prey to temptation in volatile markets. There are opportunities to generate big returns quickly in these times, although the smarter play is to focus on the long-term. Dividend stocks, especially those undervalued, will pay off in the future. Between capital gains and income taxes, you want to buy stocks that you do not need to sell off in the near-term. So go with what you know will grow.