Bad news about the housing market, subprime lending, the Federal budget deficit, a weaker U.S. dollar, and rising oil prices are understandably making many investors anxious. When this happens, investors often succumb to their fears, disrupt their portfolios, and question their long-term financial plans. While these are trying times for investors, they also can be the catalyst for becoming a better informed and more disciplined investor.

Volatility, or wide, rapid swings in equity prices, is an inherent part of investing. These price movements may seem more exaggerated when the media focuses on other economic issues, such as credit problems or the declining housing markets. But as the chart below shows, the worst 12-month stock market declines historically have been followed by periods of even greater recovery. 

While this chart demonstrates historical results and there is no guarantee of future positive returns after a prolonged stock market downturn, investors also have to confront their own emotions during difficult market periods and control the urge to sell or reduce their market holdings.

• The trailing 12-month returns were sorted from worst to best. Adjacent 12-month periods were not considered. As a result, the 12 months ended September 1974 had the lowest return in the data set, so the 12-month periods that overlapped with September 1974 were not considered.

• The trailing 12-month returns are compounded total monthly returns for the S&P 500 as reported by Ibbotson Associates. The 5- and 10-year returns are annualized total returns. Investors cannot invest directly in an index.

1. Stay in the Market
The problem is that when investors sell, they can increase their chances of missing the major market movements that signal the start of a longer recovery. Many of these major upside moves can happen quickly, often in just a few days. To avoid missing these key days, investors may want to consider staying invested and avoid panic selling. Consider this hypothetical example as illustrated in the following chart:

An individual who was invested in the S&P 500 from January 1, 1997, until December 31, 2007, would have turned a $10,000 investment into $21,789 for an average annual return of 8.10%. Alternately, an investor who panicked and sold their positions during this same period and missed the 10 best trading days in this period would have seen their return fall from 8.10% to 3.58%.* 

The simple lesson: you may want to consider staying invested since no one can predict when the market will experience its best days.

2. Invest for the Long Term
According to Dalbar’s 2007 Quantitative Analysis of Investor Behavior study, the longer an investor held their investment position, the greater their returns. Of the three types of investments studied (stock funds, bond funds, and asset allocation funds), the average investors in asset allocation funds held their funds the longest (an average of 4.9 years) over the five time periods studied (1-, 3-, 5-, 10-, and 20-years). As a result, these investors successfully weathered one of the most severe market declines in history (2000-2002).

3. Diversify Your Portfolio
Another important strategy is to diversify your portfolio. According to the Dalbar study, investors guess incorrectly about the market’s direction 75% of the time. Diversification is the process of spreading investments across a number of different types of investments (stocks, bonds, and real estate, for example), as well as in different styles and market capitalizations of equities (large-cap, small-cap, value, and growth stocks) and bonds (based on maturity and quality). Diversification enhances the benefits of asset allocation so your assets are less affected by short-term market swings than they would be if you invested in a single asset class. Numerous academic studies have found that asset allocation is responsible for over 90% of a portfolio’s performance variability over time.* Note: Asset allocation/diversification does not guarantee a profit or protect against a loss.

4. Consider Asset Allocation Portfolios
Historically, business cycle contractions last about one-sixth as long as expansions.** While no one knows when the current decline will end, now may be a good time to re-evaluate your risk tolerance. Some long-term investors may want to reallocate their market exposure.

If you want a professionally managed investment to handle this complicated task, consider using target-date and target-risk asset allocation portfolios. These funds are specifically designed to match an investor’s risk tolerance or projected retirement date with an appropriately diversified portfolio.

Target-risk funds are based on a person’s risk tolerance preferences and can offer 12 to 16 separate asset classes in one investment. Similarly, target-date funds offer asset allocation solutions based on an investor’s future retirement date. Both target-date and target-risk funds are designed and managed based on the established principles of portfolio diversification and risk management.

5. Remember the Benefits of Long-Term Investing
The bottom line: It takes discipline to keep today’s bad news from derailing your long-term investment goals. However, investors who continue to pursue their long-term investment goals should recognize that successful investing is a marathon, not a sprint.

While these tips can help you navigate through periods of market volatility, one thing to remember is that the stock market is a collective gauge of investor sentiments, negative and positive. It is the investor’s task to not be distracted by these emotional moves. These tips should help you stay focused.

Sources:
* G.P. Brinson, L.R Hood and G.L. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal, January/February 1995.
** George Hildebrand, Business Cycle Indicators and Measures, Probus Publishing, 1992.

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