First things first, I must say that right before I wrote this article, I had just read on Bloomberg that the Greeks would ask for a referendum on the bailout (that was Tuesday morning, November 1st). At that specific time, there was not a better time to talk about how to tell the difference between market fluctuations and when you are about to lose money that will never be seen again.
When the storm is only wind and showers
When you see your portfolio going up and down, there is one thing you need to ask yourself: « is it a storm or a gigantic tsunami? ». And the answer doesn’t lie in the amplitude of the fluctuations. In fact, I don’t really mind knowing how much my portfolio went down in a day, a week, a month or even a quarter. But what I really care to know is: WHY?
It has always been a fact but it’s now more clear than ever; stock markets will go through high changes. Sometimes it can go up by 30% and other times (we wish they don’t exist), it could go down by 30%. The first thing to remember is that the stock market never goes up for long enough and it always takes forever to rise (this is called perception 😉 ).
If you want to tell the difference between market fluctuations and the moment where you won’t get up after a knock-out, you need to find the cause of the changes. I can tell you upfront that most of the time, it is just a bad storm and the best thing to do is to go down into your basement with a few dvds and a bag of chips ;-).
How to reduce volatility in your portfolio
Even though it’s normal, there is nothing more frustrating than to see how much money you have lost and you quickly think “why I didn’t I leave all this money in my bank account? At least, I would have not lost what I worked hard to earn!”. So there are a few ways to reduce the volatility in your portfolio and make you feel better when the market goes down.
a) Dividend investing!
It is with no surprise that dividend investing will indeed reduce the volatility of your portfolio. While your capital will fluctuate, you will still receive dividend payouts in your brokerage account. These payments will help maintain the value of your account at a higher level when compared to a non-dividend paying portfolio. You can see the benefits of dividend investing in how I beat the market in 2011 with dividend stocks.
b) Playing with your asset allocation
Your second option is to play with your asset allocation and add bonds to your portfolio. While they don’t pay much at the moment, their low volatility mixed with their interest payments will also smooth out your negative yield. On the other hand, don’t count on bonds to make your portfolio jump back when the market is bullish.
When the storm is a hurricane that will rip your house apart
There are some moments for investors when you can actually lose a lot of money and never see it again. All the Nasdaq fans from the 90’s will tell you how painful their investing experience was during the techno bubble. But the reality is that the only way you can actually lose money and never get it back is when you are making it happen.
“Say what? If I lose money, it’s only my fault?”
It’s your fault because you have taken too much risk. The volatility of your portfolio will always finish with a happy ending if you are well invested, well diversified and you stick to your investing strategies. However, if you are after the home run or putting all your eggs in the same basket, you may end up losing big and losing your money forever.
Here are a few indicators that boost your risk:
– You invest in a single sector (techno, financials, or gold with a gold ETF for example).
– You invest in a single country (it is less dangerous for US investors, but many Canadians ignore the rest of the world and that is risky).
– You are trying to hit a home run with penny stocks or highly speculative stocks (read about how I got burnt by one of these trades).
Therefore the best way to avoid risk in your portfolio is to:
– Invest in several sectors
– Invest in several countries (and select companies that also operate in several countries)
– Ignore home run possibilities and aim for solid stocks.
– Constantly rebalance your portfolio (every 6 months)
I was looking at some of my clients’ portfolios recently and those who didn’t change their investment strategies, those who were well invested, well diversified since 2004 or 2005 are actually showing positive results (between 3% and 5% annually depending on their asset allocation). So they show a positive return even if they went through the worst year in the stock market (2008) and the recent quick bear market (April to September 2011).
They went through a lot of volatility during this period but at no time was their portfolio totally at risk ;-).