Investing in a volatile market
After an average annualized return in excess of 23 percent for the past three years, the Dow Jones Industrial Average entered the new century with its worst start in the past 80 years.
While the Nasdaq Composite index is up approximately 13 percent year-to-date, the Dow is currently down about 14 percent from its 1999 year-end valuation. The Standard & Poor’s 500 stock index is also down about 9 percent.
Yet, a significant decline in the market, even for a relatively short period of time, has recently been a rare event. In fact, the market’s positive performance during the past several years has raised many investors’ expectations to the point that annual double-digit gains in stocks are expected.
Many market indicators strongly suggest continuing positive returns, but recent concerns over inflation, rising interest rates, and high stock valuations will add to short-term volatility in the market. Declines do, and will, occur.
What steps can you take to preserve both your sanity and some of the wealth you’ve accumulated during this time of volatility?
First, some things to do:
- Focus on objectives
If your goal is the long-term accumulation of wealth for retirement, education, independence, etc., having a significant portion of your assets invested in equities probably makes sense and will serve your objectives well. However, downturns in the market are part of the process; it is not a one-way street. If you need the majority of your invested
dollars within five years, you shouldn’t be in the stock market. But if you’re invested for the long haul, maintaining a long-term perspective.
- Diversify your portfolio.
Diversification typically reduces volatility and risk. Do you have too high a concentration in one sector of the market, one management style, or even a single stock?
The dramatic appreciation of certain stocks and mutual funds during the past several years may have distorted the intended ba-lance of your holdings. Look for disproportionate weightings.
Utilizing mutual funds can be an ideal way to diversify, but don’t assume all mutual funds have diversification as their objective. Many funds intentionally concentrate their assets. Know where your potential risk expo-sure lies.
- Keep costs down.
Focusing on your cost of investing makes sense, but it becomes crucial when you are looking to preserve assets and return. The impact of a 5 percent load will be much more painful when annual returns dip into single or negative digits.
Compare carefully to assure a mutual fund with a high internal expense ratio truly delivers net performance that exceeds a less costly fund with similar objectives.
When annual performance is high, many investors tend to overlook the cost of internal fund expenses. When performance drops, these costs will have a greater proportionate impact. For example, when a fund with an internal expense ratio of 2 percent generates a gross return of 8 percent, your realized net return is reduced a full 25 percent.
- Adjust your asset allocation.
A shift toward the lower end of your desired percentage in equities. If you don’t know your total stock exposure, do the math. If you suspect the market’s potential, or your need for a return, is less than what it was originally, gradually reduce your risk by paring overall equity exposure. Your goal should be maximizing the return on the risk appropriate for your situation.
Also, monitor the actual equity percentage of any mutual funds in your portfolio. If you reduce equity exposure by downsizing your stock-oriented mutual funds, but the managers of those funds are also reducing equity concentrations, your total stock allocation could be lower than you intended.
Now, some things not to do:
Knee-jerk reactions that run counter to a well-developed strategy typically do more harm than good when managing your portfolio. As an example, the dramatic market drop in October 1987 caused many panicked traders to irrationally sell significant equity holdings at bargain-basement prices. And yet, the year ended with the market very much back in positive territory.
- Attempt to time the market.
Market timing involves trying to guess when the stock market has topped or bottom-ed and then making wholesale shifts in your portfolio. This is much different than the disciplined strategy of incrementally modifying your equity exposure within a narrow, predetermined range.
For market timing to be effective, not only do you need to exit the market at the right moment, but you also have to maneuver a timely re-entry. Over and over, history has shown this is a losing proposition.
For example, a University of Michigan study of the 1982-87 bull market showed that by investing in the S&P 500 index for the entire period, you have earned an average annual return of 26.3 percent. However, if you missed the 20 best performing days of that 1,276-day period, your annual return was halved to 13.1 percent. If your attempts to time the market caused you to miss the top 40 days, your average annual return for the entire bull market was a dismal 4.3%.
- Let the market drive your strategy.
Your investment objectives and tolerance for risk should guide your overall strategy, not recent movements in the stock market. For some investors, the stellar returns of the roaring bull market have clouded this basic tenet. Similarly, a market downturn shouldn’t have you completely revamping your well-thought-out game plan.
If your long-term financial needs and ability to handle risk have not fundamentally changed, don’t let swings in the market dictate your strategic approach.
What is the best strategy for investing in a volatile market? Often times, it’s simply reviewing your basics, knowing where you’re positioned, making appropriate adjustments, and then holding your ground.
Jeffrey Roof is president of Roof Advisory Group, an independent investment management and financial planning firm.
Investing in a Volatile Market is reprinted from The Patriot-News – Business & Your Money Monday, March 6, 2000.