News flash: The stock market can be volatile. Stocks can go up quickly, and they can go down, sometimes even faster. A lot of investors shy away from the roller-coaster ride that the market can sometimes feel like by avoiding stocks in their investment portfolio. But that’s not a good investment strategy because, over the long run, stocks provide your best chance for higher returns. This post will try to show you how and why market volatility can enhance your investment returns.
Stocks have always gone up and down, but lately they seem to move a lot faster and further. Today’s pumped-up political environment often spills over to the investment markets. Seemingly good news in a tweet about the trade war? Stocks usually go higher. Bad news on the trade war? They tend to move lower—often sharply lower. But the long-term trend of stocks (stocks in general—not individual stocks) has always been higher.
When stocks move sharply in either direction, the emotions related to investing often show up. And when emotions become entangled with investments, it’s never a good thing. We tend to hardly notice the market when it moves higher. We’ll check our statements, make a note that it was a good month or year, and put them into our filing system. But when markets move sharply lower over a short period, we take a lot more notice. Behavioral studies have shown that the pain that comes with a financial loss is twice as intense as the amount of pleasure that comes with a gain.
However, if you are managing your portfolio properly, you will learn to embrace the volatility. I won’t go too deeply into all the things that go into managing a portfolio properly. Instead, I will focus on three of the most important: making sure that your portfolio is properly diversified; regularly rebalancing across asset classes; and staying disciplined when the markets bring out emotions.
Many examples over the years could be used to illustrate how this should work. But we have a very recent, and very good, example that will show you what I mean. 2018 was a pretty good year for stocks—until October. That’s when signs of a slowing economy, the threat of higher interest rates, and concerns about a trade war with China came together to create a big sell-off.
December was particularly painful, ending a quarter that saw the S&P 500 lose almost 14%, and ending a year that resulted in a 6% loss. It was the first loss in three years and the biggest since 2008. Investors were looking for the exits as the fear settled in. But things changed quickly. A Santa Claus rally finally arrived the day after Christmas, and it carried into 2019. The S&P 500 posted a 13% gain in the first quarter of this year, the best quarter in 20 years.
So, how does volatility become your friend? First, you need to make sure your portfolio is properly diversified. You should have your investments spread across several asset classes. Low-cost index funds can give you broad exposure to U.S. and international stocks and bonds. For our example, let’s assume your portfolio is made up of 60% stocks and 40% bonds.
The next step is to review your mix regularly and rebalance when the movements of the markets result in a “drift” of your portfolio away from its 60–40 goal. By ignoring the emotions of the markets and staying disciplined to your plan, here’s an example of what could have happened in your portfolio recently:
If in September of last year, you were at 60–40% (that’s stocks–bonds), you might have been 55–45% by the end of the year because stocks had dropped so much. If you had rebalanced your portfolio back to 60–40%, you would have been buying stocks at the end of the year, after they had dropped in price.
Then, three months later, after a huge rally in stocks, your portfolio might have drifted to 65–35%. Staying disciplined and following your rebalance strategy, you would now be selling enough stocks to get back to 60–40%. So, you would be selling stocks after they increased in price.
Buying when prices are lower and selling when they are higher is the way the “investment game” is supposed to be played. However, investing is not a game. It’s a way to build wealth for you and your family over the long term. Follow the strategies discussed in this post, and you’ll find out that volatility in the financial markets can truly be your friend.
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