After a lengthy stretch of calm, stock market volatility has returned with a vengeance. On Monday, the Dow Jones index fell a whopping 1,175 points, the single largest one-day drop in history. At one stage in the day, it was down 1,600 points. UK stocks haven't escaped the carnage. The FTSE 100 has plummeted sharply over the last week, with six consecutive days of falls. The index is now down around 8% from its mid-January all-time high.
When markets are in freefall mode like this, it can be scary. Especially if you're new to investing. The media doesn't help. Newspapers and websites tend to dramatise any volatility, exclaiming that £Xbn has been wiped off the market and that investors will suffer.
So what's the best strategy to deal with such volatility?
The first thing to do when stocks are falling is to stay calm and rational. Breathe. Remember that markets rise and fall. They always have and they always will. It's part of investing.
Also, put any falls into perspective. For example, over the last two years, the FTSE 100 has risen over 20%. Add in dividends and investors have enjoyed a near-30% return. So an 8% fall is not the end of the world.
Next, it's also worth finding out why markets are falling. This can help you stay rational.
In this case, the main driver of the volatility, in an ironic twist, is that economic news from the US has been stronger than anticipated. As a result, the market is expecting multiple US interest rate increases this year. That doesn't seem like the end of the world to me.
Embrace the volatility
"Be fearful when others are greedy and greedy when others are fearful," Warren Buffett famously said. If you're a long-term investor, like myself, follow Buffett's advice and embrace the market volatility.
Many investors hate volatility. They panic when stocks fall, and sell up, often locking-in losses. But I love volatility. I've been waiting for a correction like this for a while now and I'm excited that one is finally here. Why?
Because corrections bring opportunities. When stocks fall sharply, you have the opportunity to buy high-quality companies at lower valuations. That means potentially higher profits for you in the future. Similarly, if you're a dividend investor, falling share prices bring opportunities to pick up higher yields. That means larger dividends for you in the future. When you reframe it that way, volatility isn't so scary.
What I do when markets are falling is draw up a 'best ideas' list. I make a list of the five to 10 stocks that I really want to add to my portfolio. Often, these stocks are popular companies that regularly trade at high valuations, such as Unilever and Diageo. Then, as the market falls, I monitor them for attractive entry points. It can take courage to buy when the market is falling, but over the long term, the rewards are worth it.
Of course, global markets could fall further. The FTSE 100 is up today, but it may continue falling in the near term. With that in mind, a sensible strategy is to drip feed capital into the market, bit by bit. Don't go 'all in' at once.
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Edward Sheldon owns shares in Unilever and Diageo. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK has recommended Diageo. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.