Handling Market Volatility
Posted by George T. Clarke, CPA/PFS, MSF and Rick Ropelewski, CFP, MBA
Conventional wisdom says that what goes up must come down. But even if you view market volatility as a normal occurrence, it can be tough to handle when the volatility is high (as it is now) and your money is at stake. Though there is no foolproof way to handle the ups and downs of the stock market, the following common-sense tips can help.
Don't put your eggs all in one basket
We see many new client portfolios that are top heavy in either one investment or several highly-correlated investments. Diversifying your investment portfolio is one of the key tools for trying to manage market volatility. Because asset classes often perform differently under different market conditions, spreading your assets across a variety of investments such as stocks, bonds, and cash alternatives has the potential to help reduce your overall risk. Ideally, a decline in one type of asset will be moderated by a gain in another, though diversification can't eliminate the possibility of market loss.
One way to diversify your portfolio is through asset allocation. Asset allocation involves identifying the asset classes that are appropriate for you and allocating a certain percentage of your investment dollars to each class (e.g., 70% to stocks, 20% to bonds, 10% to cash alternatives).
Focus on the forest, not on the trees
When the market vacillates sharply up and down, it's easy to become too focused on day-to-day returns. Instead, keep your eyes on your long-term investing goals and your overall portfolio. Although only you can decide how much investment risk you can handle, if you still have years left to invest, refrain from overestimating the effect of short-term price fluctuations on your portfolio.
Look before you leap
When the market goes down and unrealized investment losses mount, you may be tempted to pull out of the stock market altogether and look for less volatile investments. The modest returns that typically accompany low-risk investments may seem attractive when more risky investments are posting negative returns.
However, before you leap into a different investment strategy, make sure you're doing it for the right reasons. How you choose to invest your money should be consistent with your goals and time horizon not what the market did today.
For instance, putting a larger percentage of your investment dollars into vehicles that offer asset preservation and liquidity (the opportunity to easily access your funds) may be the right strategy for you if your investment goals are short term and you'll need the money soon, or if you're growing close to reaching a long-term goal such as retirement. But if you still have years to invest, keep in mind that, although past performance is no guarantee of future results, stocks have historically outperformed stable-value investments over time.
If you move most or all of your investment dollars into conservative investments when the market is down, you've not only locked your unrealized losses you have also sacrificed the potential for higher returns. Investments seeking to achieve higher rates of return also involve a higher degree of risk, which often equates to higher volatility.
Look for the silver lining
A down market, like every cloud, has a silver lining. The silver lining of a down market is the opportunity to buy shares of stock at lower prices.
One of the ways you can do this is by using dollar-cost averaging. With dollar-cost averaging, you don't try to "time the market" by buying shares at the moment when the price is lowest. In fact, you don't worry about price at all. Instead, you invest a specific amount of money at regular intervals over time. When the price is higher, your investment dollars buy fewer shares of an investment, but when the price is lower, the same dollar amount will buy you more shares. A 401(k) plan in which the same amount is deducted from each paycheck and invested through the plan, is one of the most well-known examples of dollar cost averaging in action.
Although dollar-cost averaging can't guarantee you a profit or avoid a loss, a regular fixed dollar investment may result in a lower average price per share over time, assuming you continue to invest through all types of market conditions.
Don't stick your head in the sand
While focusing too much on short-term gains or losses is unwise, so is ignoring your investments. You should check your portfolio at least once a year — more frequently if the market is particularly volatile or when there have been significant changes in your life. You may need to “rebalance” your portfolio to bring it back in line with your original asset allocation, which was designed to achieve your investment goals and reflect your individual risk tolerance. Because rebalancing involves selling some investments in order to buy others, investors should keep in mind that selling investments could result in a tax liability. Don't hesitate to get professional advice if you need it to decide which investment options are right for you.
Don't count your chickens before they hatch
As the market recovers from a down cycle, elation quickly sets in. If the upswing lasts long enough, it's easy to believe that investing in the stock market is a sure thing. But, of course, it never is. As many investors have learned the hard way, becoming overly optimistic about investing during the good times can be as detrimental as worrying too much during the bad times. In order to be less vulnerable to the downside of volatility be cautious about investing on margin or spending your unrealized gains.
Don't forget that while they are sound strategies, asset allocation and diversification can't guarantee a profit or protect against the possibility of loss. All investing involves risk, including the possible loss of principal, and there can be no guarantee that any investing strategy will be successful.
Remember, the right approach during all kinds of markets is to have a plan, which strikes a comfortable balance between risk and return -- then stick with it.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual, nor intended to be a substitute for specific individualized investment, tax or legal advice. We suggest that you discuss your specific situation with a qualified financial, tax or legal advisor.