How to Take Advantage of Stock Market Volatility

However, market dislocations can often provide company-level buying opportunities; there is a profound difference between making incremental portfolio changes in response to market volatility and "all-in/all-out" strategies to try to call market tops or bottoms. Benjamin Graham, the "father of value investing," stated, "The day-to-day market isn't a fundamental analyst; it's a barometer of investor sentiment." Emotional swings are often disconnected from fundamentals, creating divergences between price and intrinsic value. Investors with a well-informed point of view can take advantage of panic-driven situations to buy stocks that are temporarily undervalued or sell stocks that are temporarily overvalued.

Investors trying to take advantage of market volatility should follow a systematic framework for reviewing the investment opportunity:

1. Determine whether there are heightened risks (or opportunities) created by the market environment.
2. Evaluate whether the company's business model and financial structure is equipped to succeed during the period of market or economic instability. There are often companies with compelling business models that lack the capital to survive an extended downturn.
3. Test that the assumptions made about the intrinsic value of the company haven't changed. Changes in interest rates, economic behavior or consumer preferences are among the considerations that can validate or invalidate the investment opportunity.
4. "Look before you leap" by examining contrary opinions about the company. Seeking contrary viewpoints is a good way to identify shortcomings in the investment analysis.
5. Define "success" and "failure."  Establishing criteria to define whether an investment is working as expected or is falling short of expectations can make it easier to be disciplined about cutting losses more rapidly on losing investments.

In times like these, it is important to remember that the permanent loss of capital associated with making bad investments or selling at inopportune times is far more damaging than short-term spikes in market volatility. Most causes of permanent loss of capital are self-inflicted.  Failing to maintain enough liquidity to meet unexpected expenses increases the likelihood of having to sell assets at inopportune times. Being overly leveraged also raises the vulnerability of being a forced seller, the unfortunate fate of too many real estate investors in 2008 and 2009.  Panic is perhaps the most common trigger of permanent loss of capital and provides another argument in favor of maintaining a moderate intake of financial news.

Investors with well-diversified and liquid portfolios are better positioned to weather the storm when market volatility picks up. Successful investors such as Warren Buffett embrace the positive aspects of market volatility, with market dislocations providing periodic opportunities to invest in good companies at "discounted" prices.

Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.

Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.

Daniel is a graduate of Brandeis University and earned his MBA in Finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.