Interest rates, political agendas, and other economic forces can lead to market volatility. This volatility can stoke fears and motivate investors to make rash decisions that ultimately jeopardize their financial future. Although you cannot control the economic forces that drive market volatility, you can control how you react when volatility occurs. A well-designed financial game plan will incorporate certain strategies to help defend against the pitfalls you may encounter when managing market risk.
Perspective and Time Horizon
On January 3, 1993, the hometown crowd poured out of Rich Stadium in Buffalo, New York, after the visiting team built a 32-point lead with 13:19 remaining in the third quarter. Disgusted by the performance of the hometown team, these fans lost perspective. There was still nearly an entire half of football to be played, and the hometown team featured one of the league’s most potent offenses. By making a rash decision, these fans missed the greatest comeback in professional football history.
This cautionary tale demonstrates the importance of perspective and time horizon. According to the Social Security Administration, a man reaching age 65 today can expect to live, on average, until age 84.3. A woman reaching age 65 today can expect to live, on average, until age 86.7. If history is any indicator, there are bound to be countless market drops throughout this time horizon. Your financial game plan should help you withstand these short-term market shifts and remain focused on your long-term financial goals.
Asset allocation is the process of apportioning an individual’s investment portfolio among different asset classes, such as stocks, bonds, and cash. A well-designed financial game plan bases its asset allocation on your time horizon, goals, and risk tolerance. While stocks overall are expected to generate the highest rate of return over a long period of time, they also carry greater risk. Bonds tend to be less volatile, but they do not have the same growth potential as stocks. Cash is generally immune from market volatility, but its value may be eroded by inflation. Depending on your time horizon, goals, and risk tolerance, some combination of these three asset classes is prudent.
Once you have determined an appropriate asset allocation, you must diversify your investments within each asset class. For example, the funds allocated to stocks should be spread across a variety of holdings. Diversification may help minimize the impact of volatility while providing for more consistent returns over time.
As diversified investments perform differently, your assets may stray from the desired allocation. When the stock market is doing well, stocks may become over-represented in your portfolio, introducing more risk than intended. In order to minimize your exposure to undesired risk, you should regularly re-balance your portfolio. Rebalancing involves periodically buying or selling certain holdings to maintain the desired asset allocation. This may have tax consequences that you should discuss with your tax advisor.
Dollar-cost averaging is a systematic and disciplined investment strategy that helps to reduce the impact of market fluctuations and the overall cost of investing. This strategy requires you to invest a specific dollar amount on a regular basis. The price of the desired holdings will determine how many shares you are able to buy. This disciplined approach to investing will discourage emotional decisions and helpyou continue to move the chains toward your financial goals.
Asset allocation, diversification, and dollar-cost averaging do not ensure a profit or protection against loss. For dollar-cost averaging to be effective, investors should consider their ability to continue investing during periods of falling prices.