Some thoughts on how to manage your investments through any stock market climate.
So far, the prediction that the stock market wasn’t going to close on a good note this year seems to be unfolding as expected. Remember the saying which suggests that “however January turns out, so shall the rest of the year?” Well just as expected, our stock portfolio (along with the investment portfolios of countless investors out there) is suffering through the rough patch brought about by the credit and subprime lending crisis.
But before we all bemoan the decline of our net worth, I’d like to offer some words of encouragement and supply you with information that should alleviate some of this worry:
Investment Management Tips For An Iffy Stock Market
#1 Are you going to act? Then go against the crowd.
Should you sell, buy or trade? If I had the extra money to invest, I would dollar cost average or invest in a lump sum at these lower market levels.
We’re often told that the best time to buy into the stock market is while it’s languishing. If you’re wondering when to “jump” into the market, now may be a reasonable time, although if you’re nervous about committing all your cash into the market right now, you can do so gradually, using dollar cost averaging methods or you can stay cautious by reviewing these ways to invest defensively with new monies.
If you don’t have any additional savings to make investment purchases, then hang on. By reading the rest of this article, you’ll see why staying put in this market (though against our natural inclinations) may be a sensible strategy. Find out more about how investing in down markets can be a good move.
#2 Do nothing or at least, don’t overreact.
My spouse is the type of person who feels he needs to do something when the market moves. We discuss our options then ultimately end up doing nothing much. This is because we’re already pretty much diversified according to the asset allocation parameters we’ve adopted for ourselves. I don’t feel we need to “change the rules” in the middle of the game. If we did that, we’re just “cheating ourselves”, while shifting our asset allocation as a reaction to market developments.
The only shifting we should be doing needs to be driven by regular investment portfolio reviews and rebalancing efforts that we take to keep our asset allocation stable, regardless of what the market is doing.
#3 Wait it out. Do you have a long investment time horizon?
Too much issue is made of short-term returns, and it’s easy to feel depressed about the returns we’re seeing over the last few years. But when you look at the big picture, those losses aren’t as gargantuan as they seem.
This data table from T. Rowe Price illustrates how stock market returns “smooth out” over time and how time in the market reduces variability in investment returns. That is, the longer you stay in the market the less likely it is for you to receive extreme rates of return. More on this on my discussion about long term investing. Here are some real numbers to support this reality:
Historical Stock Market Performance 1926-2006
| One Year Returns | Five Year Annualized Returns | Ten Year Annualized Returns | Twenty Year Annualized Returns | |
|---|---|---|---|---|
| Years with Highest Returns | 1933 / 53.99% | 1995-1999 / 28.55% | 1949-1958 / 20.06% | 1980-1999 / 17.87% |
| Years with Lowest Returns | 1931 / -43.34% | 1928-1932 / -12.47% | 1929-1938 / -0.89% | 1929-1948 / 3.11% |
| Stock Market Volatility | Highly Volatile | Somewhat Volatile | Diminished Volatility | Negative Annualized Returns Are Eliminated |
Now let’s go through an example showing how a hypothetical portfolio would have fared through different stock market periods and time horizons. Suppose you had invested $100,000 in stocks at the start of each highest returning and lowest returning time period, how much would this investment be worth by the end of each designated period?
| One Year Period | Five Year Period | Ten Year Period | Twenty Year Period | |
|---|---|---|---|---|
| End of Highest Returning Time Period | $153,990 | $351,079 | $622,348 | $2,681,706 |
| End of Lowest Returning Time Period | $56,663 | $51,385 | $91,494 | $184,434 |
Conclusion: The longer you stay invested in the stock market, the less likely your investment returns will be negative; facts that should motivate us to stay the course and remain patient with our investments.
#4 Try to maintain perspective during a stock market rout.
Before you worry, it may be a good exercise to look at the real reasons for the unease in the markets. There are quite a good number of reasons for stock market corrections and downtrends, and in each situation, there’s been an eventual recovery.
The general U.S. market may tank due to a variety of factors, such as a combination of international and domestic events, from reports of high speculation in real estate markets to poor economic growth and growing debt. On some other occasions, you may point the finger at good old-fashioned market valuation — when the market runs up too fast too soon.
But you’ll have to determine if these factors are fundamentally damaging enough to hurt the market for a prolonged period of time. Are these reasons enough for you to pull the plug? If you’re investing for a long time horizon, your answer should lean towards the negative.
#5 Review these general rules for asset allocation.
Over the course of my writings here about investing, I’ve focused quite a bit on the topic of diversification and asset allocation. These were some of the best lessons I learned as I researched these topics in detail.
- I found that the optimal foreign investment allocation is 30% of your total equity portfolio. That is, an ideal international vs domestic investment allocation is 30% / 70% (foreign/U.S.) for those funds of yours invested in equities.
- Stock market diversification is best achieved with asset classes that have low correlations. Asset classes with low correlations are those whose returns aren’t “in-synch” during a given period of time.
- You can achieve great diversification with a very simple portfolio.
- Know yourself well before you invest. Use your risk tolerance, financial goals and age to determine the right amount of money you should risk in the markets.
Subtract your age from 100 (some guidelines have it at 120) to get some idea of how much stock you should be owning at this time. For example, a 30 year old is expected to own a portfolio consisting of 70% stock (100 minus 30) and 30% cash and bonds.
- How much you should invest for your financial goals should take into consideration withdrawal rates and drawdown guidelines for that money.
Copyright © 2008 The Digerati Life. All Rights Reserved.
{ 15 comments… read them below or add one }
I am kind of in an interesting situation. Having just entered the workforce less than two years ago I have had very little time to amass any sort of investment portfolio – so the dip is not affecting me in any major way.
But I also see the opportunity to buy that is going on right now but I don’t have the cash to invest because I don’t make enough to take advantage of it! Kind of lame but them’s the breaks.
This post is great advice for anybody who has never been through a down market such as myself. This is the first down market that I have experienced since I began investing. Fortunately, I have read excellent posts such as this by other bloggers as well, in addition to reading investing books that have detailed the various crazes and bear markets. I have friends who are just beginning to invest and are not happy with the immediate losses. I try to tell them that it’s going to be okay in the long run, but if you’ve never seen a market rebound you tend to think it never will.
I think too many people focus on the short term gain, especially in real estate a traditional long term market.
Like the data and analysis – BUT- the “rule of thumb” you quoted relating age and equity percentage in your portfolio? There is no good economic science behind that. If you analyze asset allocation with a goal of consumption smoothing, the ratios can look completely different and may in fact increase with age.
There as so many wise ways to invest, your post is insightful, thank you. The biggest challenge is to stop buying and invest in the future, the investment.
You should remember that the “perfect” international allocation is only in hindsight. A citizen of Russia or Japan would have performed much better over this period with much more than 30% foreign investments.
If you think that the US markets will remain (largely) unchallenged for the next three decades as they have for the past three, then sure, your allocation is fine. However, I’d suggest that only 30% international may not prove to be a diversification sweet spot indefinitely.
That’s not to say you should run out an change your allocation now just because of current conditions, but blindly projecting past economic conditions into the future (as you apparently do in your previous article on international allocation) might not be the best stratagy.
@Tough Money Love,
I’d like more clarification of what you mean. The rule of thumb I hear ranges from using 120 to 100 as the base number from which you subtract your age to figure out your allocation towards stocks. I know it’s a simplistic guideline, but I would love to hear about other areas of thought on this matter.
@Deamiter,
The range for suggested foreign allocation is 20% to 50%. I agree that economic realities change over time and these recommended parameters may shift with those changes. What I garnered from some studies (which I wrote about in my report on the optimal foreign allocation) is that the upper limit of the suggested range (50%) is based on risk assessments of the foreign markets as well as their position/representation in the global equity market. 50% represents the proportion of the global market that foreign stocks currently represent.
Here are more details on this which I wrote about in my earlier article:
“In fact, studies show that the effects of currency risk, progressively higher correlations (e.g. diminishing diversification), foreign taxes and costs outweigh any benefits of higher foreign stock allocations.”
There is also that matter of currency risk to take into consideration when working out your allocations. The caveat here as well was that I was writing from the point of view of the American investor.
The dollar is strengthening now, which affects your international investment returns (currency risk as you mentioned) so going gonzo into that right now may not be a good idea considering the headwinds.
“Know yourself well before you invest.” is probably the best bit of advice there… I know I’m lazy, so I’m going to stick with index funds. 🙂
Jim’s point about the strengthening dollar is right on. It seems that the rest of the world is starting to have some of the slowdown that the U.S. economy has faced.
Great reading. Going against the crowd (rule #1) is the key for me as people are mainly driven by freed or fear.
As Warren Buffett says “You should get greedy when others are fearful and fearful when others are greedy!”
I haven’t moved into an investment portfolio yet (that’s the goal for the 2nd half of this year) but my understanding is that they’re meant to be for the long-term. That you should buy low in order to hold for an indefinite period of time and reap the rewards. Personally, what appeals to me about this type of investing is that it allows you to be involved in lots of different businesses without having to punch multiple time clocks!
Posts like this give us prespective. When we are steep in gloom, doom and feelings of despair we need statistics and lessons of history to show that others have gone through this before.
The point has to be made, though, that the original investment should have been made on a sound basis.
Regards
When it comes to investing financially in things the main focus are return and risk. The rate of return has to be reasonable to keep up with things such as inflation and tax.
The explanation given is really comprehensive and informative. I am feeling happy to comment on this blog . I think this is useful information for blog users – How does the ordinary investor fit into the equation comprising of global factors coupled with manipulation in the stock markets?
1. Invest for the long-term. If you have an investment horizon of 5-10 years and are invested in the right sectors, chances are that you will gain
2. Invest money that you can afford to lose. In other words, do not put your entire life savings in the markets.
3. Study the market thoroughly before you invest
4. Avoid putting all your eggs in one basket. Hence, diversify your portfolio
I like your point about maintaining perspective. It’s important to have some perspective when you decide to become an investor. If volatility is something you can’t deal with, then the stock market may not be the right place for most of your funds. I agree that you should seek the big picture and try to rationalize volatility or get to the bottom of why things aren’t going your way.