Volatile Markets

I found this good article on strategies for volatile markets.  In light of the market's performance so far this month and especially today, I believe it's rather pertinent.  

Six Strategies for Volatile Markets

Fidelity Viewpoints

The markets have become volatile once again, as concerns about China's economy add to fears of a global economic slowdown. Add to that volatility in oil prices, changes in the relative strength of currencies, and expectations that the U.S. Federal Reserve will gradually raise interest rates, and the result is uncertainty in the markets.

“Nothing causes investors to question their strategy and worry about their money like dramatic moves in the markets,” says John Sweeney, Fidelity executive vice president of retirement income and investment strategies. “A natural reaction to that fear might be to reduce or eliminate any exposure to stocks, thinking it will stem further losses and calm your fears, but that may not make sense in the long run.”

In fact, what seemed like some of the worst times to get into the market turned out to be the best times. The best five-year return in the U.S. stock market began in May 1932—in the midst of the Great Depression. The next best five-year period began in July 1982 amid an economy in the midst of one of the worst recessions in the post-war period, featuring double-digit levels of unemployment and interest rates.

What does this mean? It may not be prudent to bail out of the market when it is volatile. What is appropriate: Be prepared.

“Market volatility should be a reminder for you to review your investments regularly and make sure you have an investment strategy with exposure to different areas of the markets—U.S. small and large caps, international stocks, investment grade bonds—to help match the overall risk in your portfolio to your personality and goals,” says Sweeney.

Here’s how.

1. Have a strategy.

Your time horizon, goals, and tolerance for risk are key factors in helping to ensure you have an investment strategy that works for you. Your time horizon is the amount of time you can keep your money invested. Your tolerance for risk should take into account your broader financial situation such as your savings, income, and debt—and how you feel about it all. Looking at the whole picture can help you determine if your strategy should be aggressive, conservative, or somewhere in between.

2. Be comfortable with your investments.

If you are nervous when the market goes down, you may not be in the right investments. Even if your time horizon is long enough to warrant an aggressive portfolio, you have to be comfortable with the short-term ups and downs you'll encounter. If watching your balances fluctuate is too nerve-racking for you, think about re-evaluating your investment mix to find one that feels right. But be wary of being too conservative especially if you have a long time horizon because more conservative strategies may not provide the growth potential you need to achieve your goals. Set realistic expectations, too. That way it may be easier to stick with your long-term investment strategy.

3. Diversify.

One of the most important things you can do to help manage the risk of volatile markets is to diversify. While it won't guarantee you won't have losses, it can help limit them. It was put to the test during the extreme market volatility in 2008.

Look at the performance of three hypothetical portfolios: a diversified portfolio of 70% stocks, 25% bonds, and 5% short-term investments; a 100% stock portfolio; and an all-cash portfolio (see chart below).

By the end of February 2009, both the all-stock and diversified portfolios would have declined. But diversification would have helped reduce losses compared with the all-stock portfolio.

Now look at what happened when the market recovered. Our hypothetical all-stock portfolio would have risen the most, followed by the diversified portfolio, and then all cash. This is a good example of how such portfolios can behave in rising markets. If the market continues its upward trend, the diversified portfolio might gain less than the all-stock portfolio but more than the all-cash portfolio. Diversification can help to manage the risk level of the portfolio.

So how do you diversify? First, consider spreading your investments among at least the three core asset classes—stocks, bonds, and short-term investments. You may also want to include other assets, like real estate securities, which are not always closely correlated with the core asset classes. Then, to help offset risk even more, diversify the investments within each asset class.

4. Do not try to time the market.

Attempting to move in and out of the market can be costly, particularly because a significant portion of the market’s gains over time have tended to come in concentrated periods. Many of the best periods to invest in stocks have been those environments that were among the most unnerving. Investors face long odds in trying to time the ups and downs of the market, and Fidelity data shows they tend to increase their allocations to stocks ahead of downturns and decrease their exposure just prior to market rallies.

5. Invest regularly despite volatility.

If you invest regularly over months, years, and decades, you can actually benefit from a volatile market. Through a time-proven investment technique called dollar cost averaging, you invest a set amount every week, month, or quarter, regardless of how the market's doing. Over the years, you’ll buy shares of each investment at varying price levels. As a result, the average price per share of your investments may be lower than if you invested all your money at once. More importantly, you avoid the temptation of trying to time the market. (Periodic investment plans do not ensure a profit or protect against a loss in a declining market.)

6. Consider a hands-off approach.

To help ease the pressure of managing investments in a volatile market, you may want to consider an all-in-one fund or professionally managed account for your longer-term goals such as retirement. These funds provide diversification with exposure to various asset classes and investment styles in a single fund, with the added benefit of professional asset allocation.

The bottom line

Rather than focusing on the turbulence, wondering if you need to do something now, or what the market will do tomorrow, it makes more sense to focus on developing and maintaining a sound investing plan. A good plan will help you ride out the peaks and valleys of the market, and may help you achieve your financial goals.

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