Volatility
A storm gathering over the
Hudson River as seen from Peekskill.
With all the recent talk about market volatility, you might think that it's
an unusual phenomenon. In reality, stock market declines aren't
unusual. If you look at the returns of the S&P 500 Index (broadly
representative of the U.S. Stock market) over the past 50 years, or 200
quarters - the stock market has declined 63 times, or nearly one third of
the time. (This includes data up to 2001.) In addition, there have
been seven times over the past 50 years when the stock market (as
represented by the S&P 500) lost more than 10 percent in a quarter. But
there have also been 32 quarters during this same time period when the
market posted double-digit gains. And, while past performance is no
indication of future results, it's important to note that markets can move
quickly, in either direction.
DON'T TRY TO GUESS
In an effort to predict whether a particular stock market will go up or
down, some people look at which direction the hemlines on women's dresses
are moving. These have been studies that "prove" rising hemlines lead to
rising markets.
Other "theories" track whether the American League of the National League
wins the World Series. Again, you may find what statisticians call a
correlation between American League wins and rising markets, but not
causation, that is, proof that one thing makes another thing happen.
PUT IT INTO PERSPECTIVE
No one can predict how long the current market volatility will last - will
it be short-lived as in October 1987 when the market declined for three
months, or will it last as long as the one in the early 1970, that lasted 21
months? There's just no way to predict how long it will last. "Market
volatility is not good (for the investor) if your time horizon is two or
three months ... and volatility doesn't change the reason you invest. If you
want to retire at age 55, or you're trying to put your kids through college,
the fact that the market's volatile or not, should not change the underlying
principle of why you're investing."
IF THINGS LOOK BAD TO YOU NOW...
In the midst of volatile market, it's easy to believe that the bad news will
go on forever. But think back on all the political and economic difficulties
the United States experienced over the last half of the 20th century and
consider this: a $10,000 investment in the S&P 500 index would have grown to
more than $3.3 million!
TALK TO YOUR FINANCIAL ADVISOR
If market volatility is making you nervous, it may be time to review your
investments and to consider investment opportunities that may reduce the
volatility of your portfolio. Make sure your investments are diversified, in
other words, don't put all of your assets into one market sector. If you
focus on just one sector, you are not able to manage market fluctuations as
well. If your portfolio is diversified, even if one fund is down, others may
be up, and your portfolio could still be growing. For example, in the market
decline of the early 2000s, while some investors - especially those heavily
weighted in the technology sector - felt the pain in their portfolios, other
investors who owned value stocks - that lagged during technology's ascent -
enjoyed solid returns and were happy they didn't give up on value. While
diversification doesn't eliminate the risk or potential loss, through
diversification you are better able to manage the effects of market
fluctuations on your portfolio.
There are three main ways to diversify your equity portfolio: by country,
market cap and investment style.
WHEN THINGS ARE OUT OF (YOUR) CONTROL.
Investing can seem complicated, but when all is said and done, there are
only three things that affect how much your assets will grow:
1. How much you invest.
2. How long you invest
3. The rate of return your investments earn.
When markets get rocky, people tend to focus on number three - the one
element you cannot control. But even the most powerful person in the world -
whether that's the President of the United Sates, the Chairman of the
Federal Reserve or the head of the largest corporation on the planet - can't
determine how markets will perform.
KEEP YOUR FOCUS
Since you can't control how markets will perform, focus on what you - and
you alone - can control: how much you invest (number one), and how long you
invest for (number two). The only way you're ever going to have an
opportunity to get into the market at the right time, because no one can
time the market, is to develop a strategy that says "I don't care if the
market's up; I don't care if the market's down. I've got a good financial
advisor who has me on a "dollar cost averaging plan", and I'm putting a
certain amount of money in the market, no matter where it is." Then you get
to benefit from the volatility in the marketplace."
CONSIDER DOLLAR COST AVERAGING
With dollar cost averaging, you make smaller investments at regular
intervals over a period of time, instead of a large, one-time investment.
Since you are investing the same dollar amount each period, you typically
purchase more shares, when prices are low and fewer shares when prices are
high, using the market fluctuations to your own investment advantage.
Let's work through a hypothetical example. You've decided to invest $5,000
in a stock mutual fund, in $1,000 monthly investments over a five-month
period. During a fluctuating market (where prices are rising and declining)
here's what might happen.
Average share cost: $4.65
($5,000/1076 shares)
Average share price: $5.00 ($25/5
purchases)
TIME - NOT TIMING - MATTERS MOST
If you follow the stock-market
pundits, then you might be tempted to believe that the best way to improve
your returns is buying the "right" investment at the "right" time. Of
course, the pundits tend to disagree about what to buy, and when.
Since it is always better to invest
on the basis of what you can know rather than what you cannot know, consider
this:
You cannot know what the returns on
an investment will be over time, what rate of return you earn from year to
year, or whether your return for any particular year will by negative or
positive.
On the other hand, you can know
that, regardless of the average annual rate of return, the more time you are
invested, the more money you will make. In fact as the chart indicates, an
investment earning a lower rate of return, but for a longer time, will often
outperform an investment earning a higher rate of return for less time.
