Over the past six weeks it seems that every major publication has printed stories almost daily about the volatility in the market. As an investor, even if you view market volatility as a normal occurrence, it can be tough to handle the ups and downs of the market when your money is at stake.
Although there is no way to avoid the volatility of the stock market, we hope the following perspective can help. Let’s start with what volatility is and why we shouldn’t fear it. The true nature of volatility is the unpredictability of short-term returns. These temporary declines are the driver and the reason that investors are rewarded for their ownership of stocks over bonds.
Diversification of your investment portfolio is paramount for managing market volatility. Because asset classes perform differently under market conditions, spreading your investment assets across a variety of investments such as equities, bonds and alternatives has the potential to help reduce your overall risk. Ideally, a decline in one asset class will be balanced by a gain in another, although diversification can’t totally eliminate the possibility of market loss.
As we watch the market go up and down, it’s easy to become distracted by the day to day fluctuations. However, you should stay focused on your long-term goals and your overall portfolio because short-term price fluctuations are the rule, not the exception. Each year since 1980, the S&P 500 has experienced an intra-year correction averaging 14.2%. Over this same 25 year period an investor who ignored the short-term volatility would have been rewarded with an 11.8% annualized return resulting in 50 times their original investment.*
When the stock market is down, the silver lining is the opportunity to buy shares at lower prices. One way to do this is by dollar cost averaging - investing specific dollar amounts of money at regular intervals. If prices are higher you buy fewer shares but when prices are lower and you are investing the same dollar amount, you will purchase more shares. A well-known example is a 401(k), IRA, or workplace savings account. Although dollar cost averaging doesn’t guarantee that you make a profit or avoid suffering a loss, it may result in a lower average price per share if you continue to invest through all types of market conditions.
Focusing too much on short-term gains or losses is unwise but so is ignoring your investments. History has proven that the stock market is the best place to get long-term investment returns. You should review your portfolio when the market is particularly volatile or when significant changes in your life occur. This provides the opportunity to rebalance your portfolio and bring it back in line with your investment goals and risk tolerance.
As many investors have learned the hard way, becoming overly optimistic during good times can be as dangerous as worrying too much during the bad times. The best approach during all market conditions is to be realistic. Determine a comfortable balance between safety and return, have a plan, and stick with it.
As legendary investor, Peter Lynch, wrote in his book Beating the Street, “The key to making money in stocks is not to get scared out of them”.
* The time period reported is from 1/1/1980 – 12/31/2014. The S&P 500 is a representative sample of 500 leading companies in leading industries of the U.S. economy. Indexes are unmanaged. It is not possible to invest directly in an index. Returns include the reinvestment of dividends. Past performance is not indicative of future returns.