Can I let you all in on a little stock market secret? This is very privileged information so please cover your screen while you read this so that others will not see our little secret. Ok, ready – here it comes………..The stock market is volatile and can go up and down a lot!![ad#tdg-embedded]
Seriously though, the stock market does only two things on any given day. It either goes up, or it goes down. Our job as investors is to determine how to deal with it and not make stupid emotional decisions during the dynamism. In this post, I suggest that there are 8 ways an investor can deal with volatile markets. I am sure there are more and would be interested to hear your suggestions – please use the comments to add to this list.
1. Accept that the markets are volatile
The first and easiest way to deal with volatile markets is to simply recognize that the stock markets are volatile. Your assets will go up and down no matter what you do – unless of course you are all in cash.
2. Really understand your risk tolerance
It is our job as investors to completely understand how much of these swings we can emotionally handle. Go and take the test at Index Fund Advisors to determine what your risk tolerance is. Ensure you answer the questions honestly!
3. Ensure your asset allocation meets your risk tolerance
Your balance between stocks and fixed income will determine how your portfolio will react to volatility. The higher the percentage of stocks in your portfolio and the more you must accept that your portfolio value will change. If you can’t keep your emotions in tact during the volatility you will make poor decisions and hurt your returns. Keep you asset allocation in line as close to target as possible.
4. Control your costs
Investment fees erode your investment account value over time. At first it happens slowly but over time it accelerates as you have more value in your portfolio. Ensuring you keep a low cost structure to your portfolio will minimize this erosion and actually make your portfolio seem less volatile (i.e. you lose less to fees and keep more of your money).
5. Keep your expectations realistic
If you expect your portfolio to return 20% every year you are in for a surprise – it ain’t goin’ to happen! However, if you set your expectations at a realistic level then you will not be upset if you are off the mark drastically. Historically the market has returned around 9% to 11%. There are many (John Bogle and William Bernstein included) who think that we are in for a period of much lower returns – like 4% to 6%. If you understand this and keep your expectations realistic you will not panic when things do not go according to plan.
6. Invest regularly
An investor with a long-term perspective can take advantage of market volatility by investing both in good times and in bad. In fact, I have seen it suggested that the best time to invest is during those bad times. If you set up an automatic investment plan then you will not have to decide when to invest – you just do. You cannot time the market.
7. Sell only when you need the cash
My suggestion is to never sell, but if you have to then do so only when you actually need to. Selling into a down market does nothing more than solidify your paper losses into actual losses. As stated earlier, the market is going to move no matter what you do. It is your actions (i.e. selling) during the down times that will impact your actual returns.
8. Diversify, Diversify, Diversify
If you hold one stock and it goes down then you are hooped. If you hold a core portfolio of index funds and perhaps some strong individual dividend growth stocks then your results will not be tied to the fortunes of only one stock. Diversification spreads your risk around and if done properly will reduce portfolio risk.
This also goes for properly managing your employer stock purchase plans, stock options etc. If you hold too much in your employer’s plans then you are at a huge risk of loss. Even if you think your company is the best in the world, stuff happens (i.e. Enron) and with too much in your employer’s stock plans can lead to huge losses.
It was valuable for me personally to create this list as it reminded me of what it important for investment success. Each of these 8 things have helped me deal with the volatility of the markets and will continue to do so as the market goes up and down. In essence, there is no use fighting that the market will go up and down – just recognize that it will and work with it.