They say volatility is the price you pay for higher returns in the market. After a very nice run in the market over the last decade, investors were reminded of this quote recently as the last week of February saw U.S. stocks have their worst week since the financial crisis. The losses were everywhere: The Dow Jones fell 12.4%, capping off its worst month since 2009. All 11 of the S&P 500's sectors fell into the red for 2020. According to Dow Jones Market Data, about 95% of stocks in the S&P were down more than 10% from their highs. It reminded me that despite most of us having lived through the Dot.com bubble in the early 2000s and the financial crisis of 2008, we get very short memory when things are going well and throw caution to the wind with our investments.
This begs the question: how should you be constructing your portfolio to dampen the effect of these periodic market fluctuations?
The answer will differ from person to person. A few key points to look at:
- Time Horizon: The first thing to ask yourself is what your time frame is. This could be time until retirement or time frame until you want to use your funds for a down payment on a home. Different goals have different time frames associated with them and, thus, different investment strategies. An investor that is currently in retirement and who needs to re-create his or her paycheck to fund their retirement has a much different time horizon than a 24-year-old who is saving for retirement and has time on their side to ride out the volatility of stocks.
Time horizon isn't everything, though.
- Know yourself: Given the long-term superior performance of common stocks, why do some long-term investors invest in bonds or treasuries? The answer is the fear of that pesky volatility. The fact of the matter is many investors let their emotions get in the way of rationale. The more stocks go down, the more likely many investors are to sell those stocks. This could lead to not only realized losses but missing out on the rebound in stock prices that could eventually follow. Many people overestimate the amount of risk they are comfortable with, especially in times like the last decade when the market has been rising. Now is a good time to analyze what your true risk tolerance is.
- Understand Risk: It is important to understand the risks you face with your investments. There are very little investments out there that come with no risk at all. You must think logically about which is more important to you: The volatility risk that comes with stocks or the erosion of purchasing power via inflation that comes with cash and some bonds.
- Investment Policy: Be sure to create yourself a written investment policy. This is a coherent set of guidelines for managing financial assets that is in line with your goals and realities of the market. This will serve as the basis for developing an investment strategy and reviewing it on an ongoing basis. Most importantly, it is going to provide direction when direction is needed the most - when the market is in turmoil and your head is filled with uncertainty and doubt. Make sure this policy is realistic, has a long-term perspective, and is very clearly defined.
How do I best combat all of this? Asset allocation is a great place to start. A diversified portfolio can counter many of the risks we face as investors. Different broad categories of investments have, over time, exhibited varying rates of return and price volatility. A mix of cash, short term bonds, and annuities can help counter price volatility while growth stocks and equity index or mutual funds can help with purchasing power risk. Finding the right mix for you is the important part of the investment process.
Remember: risk tolerance and, in turn, asset allocation is ever changing. This should not be set in stone! Re-evaluate these things with yourself, your spouse, and/or your advisor as needs and goals change and you will be well on your way to having a more sound approach to investing.
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