collage of money, charts, student working and graduating

Coping with Market Volatility

‘Housing Crisis,’ ‘Recession,’ ‘Credit Crisis,’ ‘Subprime Loans’ … media buzz words that are pretty hard to ignore as they are a major part of many news stories. Needless to say, the last couple months have been pretty rough for investors. All three major US market indices (Dow, Nasdaq, and S&P 500) are all down close to 10% (or more) just during the first three weeks of 2008 alone. Unfortunately, many people are reacting to the market volatility emotionally rather than rationally …

Fluctuations in the stock market are normal; for investors that can maintain a ‘cool head,’ volatility can present an opportunity as opposed to a cause for concern. In gleaning many recent news articles about everything that has been going on with the market, consider the following:

AVOID EMOTIONAL DECISIONS/MISTAKES

When people read about market returns (i.e., the S&P 500 has returned an average of 10.3%/year over the past 80 years), many people envision a scenario where investing money will yield a 10% return every year. Wouldn’t that be nice! Amazingly, during those 80 years, on only 6 occasions did the market return the annual average plus or minus 3% (an annual return between 7.3% and 13.3%). Sounds to me like volatility is a normal part of investing … Investing regularly/ automatically every month (in up and down markets) is one of the easiest way to avoid the risk of emotional investing.

AVOID THE URGE TO MICROMANAGE

Lots of people have the urge to constantly watch the market – this can easily lead to irrational action. A bad day in the market emotionally feels much worse to people than a good day in the market feels good. Looking under a microscope in this manner also makes it much more challenging to maintain a long-term perspective/ strategy.

CONSULT OTHERS

There are a lot of resources (web, professionals, etc.) available to assist you with this process. Don’t feel like you need to do everything on your own unless you feel comfortable doing so. Get a financial “check up” where someone else can take a look at what you’re doing with your money and offer potential suggestions/ recommendations. Plenty of smart people seek the advice of others – I’m sure you’ve read that everyone believes they are “above average” drivers; obviously everyone isn’t. Similar studies find that investors tend to overrate their skills/knowledge.

CUSHION

In times like this, the value of an emergency fund becomes more apparent. It is wise to have a cushion of income to cover 2-3 months worth of expenses in a “secure” (no risk) account so that if you need money, you aren’t forced to sell assets to meet short-term needs.

DIVERSIFY

Spreading your investments among various types of asset classes, US and non-US, etc. won’t necessarily keep your account from losing value in a down market, but it can help to temper losses. It should be a key part of your investment strategy.

MAINTAIN PERSPECTIVE

Obviously easier said than done… For individuals with a long-term horizon, keep in mind that there has not been any 15 year window between 1926 and 2006 when the stock market has lost value.

STICK TO YOUR STRATEGY

Hopefully you had a rational justification for your investment strategy; if so, the key is to stick with that strategy through the ups and downs of the market. Trying to “time” the market (particularly during high levels of volatility) is not a smart move. During the past 10 years (1/1/97 to 12/31/06), despite a lot of market volatility (time frame includes the tech boom as well as bust), the S&P 500 returned an average annual return of 8.4%. If you had missed the ten best days during that time, you would have earned 38% less money; and if you had missed the twenty best days during the decade, you actually would have lost money! Create a strategy and then stick with it.

UNDERSTAND THE RISKS INVOLVED

Past performance may be comforting, but ultimately, there is no guarantee of anything in the world of investing. Risk is real. Understand those risks PRIOR to investing money. During turbulent times, use it as an opportunity to better understand risk, allocation, and other important aspects of investing so that you can avoid making future costly mistakes. Now is the time to educate yourself, not the time to emotionally react. The OFS section on investing is a great place to begin/ resume the learning process:
http://financialsuccess.missouri.edu/investinghome.htm.

OTHER ITEMS OF INTEREST