Whiplash is a neck injury due to a forceful, rapid back-and-forth movement of the neck… like the cracking of a whip.
Most whiplash injuries happen when you’re rear-ended in a vehicle.
Whiplash happens because nobody expects to be suddenly jolted forward. Unless you’ve got your eyes glued to your rearview mirror, you just can’t see it coming.
You’re totally unprepared for someone smacking into your rear bumper.
Whiplash can also happen in the stock market. That’s when stock prices move sharply in one direction one day, then move in an equally sharp and violent opposite direction the following day.
It leaves a lot of investors panicked and traumatised.
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We just had a big taste of this
Between December 19 and December 24, the S&P 500 Index dropped 6.2 percent as investors became increasingly worried about the impact the U.S. Fed’s rate hikes were having on the economic outlook.
But on December 27, the S&P 500 Index was up 5.9 percent – nearly erasing the huge losses suffered the previous days.
That’s a 12.1-percent swing in just five days.
By the end of it all, traders and analysts on Wall Street were scratching their heads wondering what had just happened.
Hong Kong went through the same thing in early January.
Between December 31 and January 3, the Hang Seng Index plunged 3 percent. Two days later, it was up 3.1 percent.
Meanwhile, on December 25, Japan’s Nikkei 225 Index dropped 5 percent in one day.
But after two trading days, it had risen 4.8 percent. Again, wiping out almost the entire massive loss suffered just a day prior.
Stocks recovering sharply from a selloff is a good sign.
But market whiplash can lead to investment regrets for those who panic and end up selling just before the markets turn up.
How to avoid market whiplash
Investing is a forward-looking process. You invest today based on expectations of returns in the future.
The problem arises when we’re caught off-guard by sudden, unexpected moves. Sometimes, these moves lead to decisions based on emotion instead of facts.
And the truth is, we can’t stop market whiplashes from happening.
But there are things you can do to prepare for these market whiplashes…
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1. Know when volatility is rising
Market whiplashes like the ones we saw in December are the result of increased volatility in the markets.
For the U.S., this volatility is measured through the Volatility Index (or VIX).
It’s based on option prices of individual stocks in the U.S. S&P 500 Index. When investors expect more price fluctuation (that is, for prices to bounce around more), the VIX goes up. And volatility is greatest when markets fall. That’s because investors are fearful and they take measures to protect their investments.
For example, in the two months running up to the December market whiplash in the S&P 500 Index, the VIX had been trading at an elevated level above 20 (as you can see in the graph below).
That was a sign of increasing investor anxiety. Knowing that would have helped prepare investors for a sudden sharp move in the markets.
One of the best ways to avoid getting caught up in a market whiplash is to have a properly diversified portfolio.
Diversification doesn’t mean just owning different types of stocks. It means spreading your risk across different types of assets – including gold, fixed income investments (i.e., government bonds), real estate and even other currencies. And whenever possible, make sure to own a variety of these assets in different markets or countries.
This way, when one or more groups of assets in your portfolio decline, there will be other holdings that rise to help balance out the losses.
For instance, when the S&P 500 Index fell 6.2 percent between December 19 and December 24, 2018, gold gained 1.2 percent.
3. Keep your stop loss limits
Stop loss limits are one of the most important tools in investing. It sets a predetermined price that, if breached, will result in an immediate sale of your investment.
This is designed to preserve your capital as well as any gains you might have.
Stop losses take the emotion of selling a losing position, so you can live to fight another day.
When you’re afraid of getting whipsawed by the markets, the last thing you should do is remove your stop loss limits.
They are there for a purpose – to protect you from further losses. After all, stocks can continue to fall before they start to turn up.
If you are stopped out because of a market whiplash, you can always reassess your investment and establish a new position if the fundamentals continue to be favourable.
4. Don’t obsess over things beyond your control
Investors today have many tools at their disposal to control different aspects of their investments.
You have control over what investment you decide to make, the price you pay for it, how much to invest, when to sell (as long as you’re not on margin), and what do to with dividends (i.e., reinvest them, deposit in the bank, or spend).
But market whiplash is beyond anyone’s control. It will continue to happen in the future, in greater frequency… with bigger, more violent moves. So be prepared for these market whiplashes… diversify your portfolio… follow your stop losses… and don’t obsess over things you can’t control.
Editor, Stansberry Pacific Research