Take advantage of volatility

See how volatility can be an opportunity to put cash to work.

At a glance

Expected stock volatility declined after the US election, with the prospect of divided government reducing the risk of radical policy shifts. But uncertainties remain, especially over the course of the COVID-19 pandemic, which could lead to renewed market swings. Meanwhile, with stocks near to record highs, many investors fear entering markets at the wrong time. We believe investors should stick to a plan for entering markets and stand ready to take advantage of future spikes in volatility to earn yield.

Navigating an uncertain environment

Expected volatility fell swiftly in the wake of the US presidential election. The VIX index of implied US stock volatility fell from a peak of 40 ahead of the 3 November election, pricing daily moves of around 2.5% in the S&P 500, to 24 by mid-November, its lowest level since February. The decline partly reflected reduced uncertainty over US public policy. We expect a divided government – with Democrat control of the White House and Republican control of the Senate – to diminish the potential for radical US policies.

But many investors remain concerned that the lull in volatility will be short-lived. Plenty of uncertainties remain, especially regarding the course of the COVID-19 pandemic. Infection rates and hospitalizations in many parts of the world climbed to record highs in November. Meanwhile, with equity markets close to record highs, more investors have been worried by the risk of poor market timing. That has increased the temptation to sit on the sidelines in cash.

But that approach can be extremely costly. With central banks keeping interest rates at low levels and overall looking likely to accept moderately higher levels of inflation (e.g., above 2%), cash and the safest bonds are likely to deliver negative real returns for the foreseeable future. So to protect purchasing power, investors should keep cash holdings to a minimum and invest the rest for long-term growth.

There is no perfect time to enter the market, but even if there were, the approach yields little benefit. An investor putting USD 1 from their monthly paycheck into the S&P 500 since 1945 would have grown their portfolio to USD 253,645 if they put the cash to work straight away each month, or to USD 261,699 (a paltry 0.03% p.a. more) with perfect timing, only investing at levels the market never subsequently dropped below.

Since time in the market typically matters more than timing the market, we believe it is better to put money to work straight away. For a 60% stock, 40% bond portfolio, phasing in cash over 12 months would underperform an "all-at-once" approach by an average of 4.4%.

But this approach can feel too risky for some investors, so for these investors we recommend they take advantage of the volatile environment by:

Averaging in for risk assets

For investors looking to protect against the risk of bad timing, we believe an optimal strategy is "dollar cost averaging" their planned allocation to riskier assets. We recommend establishing a set schedule—generally within 12 months or less—in order to reduce the cost of missing out on gains. In addition, we recommend accelerating each phase-in "tranche" if there is a market dip of at least 5% or 10%.

Considering a put-writing strategy

A put-writing strategy works by selling a put option, representing the right to sell the option buyer a security or exchange-traded fund (ETF) at an agreed-upon price—typically a discount to the current market price. If the market does not fall, the option expires worthless, and the put-writer keeps the premium. If the market falls, the put-writer—who had been intending to increase exposure to equities anyway—ends up buying the stock at the agreed-upon price but also keeps the premium, reducing their effective cost. While this strategy is not without its drawbacks, we believe it can help investors who can implement options to mitigate the drag on returns as they systematically enter the market. To further reduce the potential risk of missing out on a “runaway" market rally, the premium from selling the put option can also be used to fund call options to enhance upside exposure. For example, as an alternative to being long on commodities where we have a positive view, the pickup in option volatility across all precious metals offers an opportunity to sell puts and earn yield from the option premium. Similarly, in oil, for those who have a higher risk tolerance, we recommend considering selling puts in Brent crude.

Using structured investments

As an alternative to directly purchasing options strategies or other derivatives, some investors may be willing to fully commit their cash upfront in exchange for a structured investment that provides asymmetric exposure to the market—for example, levered upside participation, a degree of capital protection, or a fixed coupon payment until maturity.

Be the first to know

There’s more coming soon. Get updates direct to your inbox to read it first.

So we recommend sticking to a financial plan that avoids excessive time out of the market, which can be a drag on long-term returns.

Key investment takeaways:

  • Investors can be reluctant to put large sums to work straight away, especially during periods of uncertainty.
  • We favor three approaches for those concerned about the risk of bad market timing, but who also want to manage opportunity cost: establish a schedule for averaging into risk assets; consider put-writing strategies to take advantage of dip-buying opportunities; and using structured investments.
  • In the end, it is time in the market that matters more than timing the market.

Interested in more content?

Subscribe to our newsletter for the latest investment views.

Ready to start a conversation?

Together we can start working towards your future.

Are you a UBS employee or UBS Advisor?

For UBS employees, accessible within UBS infrastructure only.

Recommended reading