October 2011 Volume 31, Number 10

It’s All Greek to Me

Investors may have to learn to live with greater volatility in the markets.

A few years ago, most investors would have scoffed at the idea that a country like Greece could rattle the global economy. But the past two years have proven that, particularly in times of crisis, the world’s stock and bond markets are intimately tied together. “U.S. financial companies have nearly $200 billion in net exposure to Greece, Ireland, and Portugal,” wrote Federal Reserve Chairman Ben Bernanke in a letter to Congress on July 14. “But this amount is manageable relative to their capital.”1

The bottom line is that the stock market has had increased volatility during the last two months due to the European debt crisis. I wish I could say that the volatility is behind us. But, as one portfolio manager recently put it, “volatility may become the new status quo.”

Dramatic swings in financial markets – particularly steep drops in stock prices – may cause you to wonder if you have the right mix of investments. Some investors begin to stress about how market volatility will impact their financial goals, such as funding retirement, college education, or a home purchase. As a general rule, it’s better to avoid making abrupt changes to your investment strategy in response to short-term market shifts. Here are four things to consider when confronting market volatility:

1) Do you have the right investment strategy that is in harmony with your risk tolerance?

A well-thought-out financial plan and investment strategy can help to provide the confidence needed to cope with market volatility. A financial plan should provide a clear roadmap for achieving a range of goals – from paying off your home to investing for retirement.

Your investment strategy should include an asset allocation – or mix of investments – that matches your financial goals and risk tolerance. Stocks may help to address the long-term risks of inflation and outliving your savings in retirement. And income-producing investments, such as bonds, may help temper market volatility and meet income needs in retirement.

It’s also important to maintain an emergency fund in very safe investments. Keeping funds on hand to meet near-term expenses could help you stay the course with riskier investments, such as stocks and bonds, over the long term.

2) We can learn lessons from the previous bear market.

Many investors who felt compelled to sell during the downturn discovered that their asset allocation was too aggressive for their risk tolerance. For a long-term investment strategy to work, you must be able to stick with it. If you feel that market volatility is jeopardizing your financial goals, it may be time to consider adjusting your investment mix for a better balance of risk and return.

Investors who sold near the bottom of the 2008-2009 bear market locked in steep losses. The market plunged 43% from its peak in October 2007 to its trough in March 2009, based on the Russell 3000® Index, a proxy for the U.S. stock market. Investors who stayed the course benefited from the market’s strong rebound, recouping about 97% of their losses by April 2011.2 Although the market’s future direction is impossible to predict, past experience illustrates the benefits of staying the course, rather than reacting to sudden market shifts.

3) Diversification can help protect your portfolio from market volatility.3

Diversification means owning different types of investments, rather than being concentrated in only one or two. Examples include U.S. and international stocks, bonds, real estate, and guaranteed investments. It also means owning different types of stocks, such as large, medium, and small companies, and various kinds of bonds, such as Treasury, corporate, asset-backed, and mortgage bonds.

Diversification can help manage risk because different types of investments tend to rise and fall at different times or to different degrees. Since it’s impossible to predict which investments will perform better at different times, keeping a broad range in your portfolio can be beneficial. When stocks are going down, for example, bonds that produce steady income can help to reduce losses in your portfolio. Even if all types of investments are falling – as during the last bear market – having the right asset allocation and sticking with your plan may be the best approach.

4) Market timing – jumping in and out of the market – may incur greater losses than staying put.

It’s important to have a long-term investment strategy that doesn’t change with market movements for one reason: The market’s ups and downs are impossible to predict. Studies show that trying to time the market – by moving in and out of investments – is a losing strategy over the long term. Inevitably, most investors end up buying and selling at the wrong times, producing much worse performance than if they had simply stayed in the market.4

When investors try to time the market, they usually wind up chasing performance. They tend to buy after an investment has already gone up and tend to sell after the investment has gone down. The resulting pattern of buying high and selling low can destroy long-term performance.

In summary, volatility is likely to continue in the coming months due to the European debt crisis. Does that mean that your long-term investment strategies have changed? No. But if you have questions about your portfolio, would like to discuss the economy in general, or would like to reassess your risk tolerance, please don’t hesitate to give me a call.

 

1) cnbc.com September 6, 2011
2) Returns shown are based on a stock index, not actual investor returns. Index performance does not include investment fees or transaction costs.
3) Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.
4) TIAA-CREF Individual & Institutional Services

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