Is Volatility your Enemy or your Friend?

by Rob on September 5, 2011

With recent media pieces alarming investors about stock market volatility (a recent USA Today headline proclaimed, “Volatile Market Dashes Investors”), I feel the need to put things in perspective.

It’s true that if you’re not invested properly – and were planning on selling stocks to pay for your kid’s college education later this month, you might be feeling some pain right now (in a future post, I will talk specifically how to invest for college). Volatility is not your enemy; however, until you react to it, panic, and sell stocks at the bottom.  Unfortunately, human investors (which include most of us) are behaviorally predisposed to do just this.

Instead, think long-term and work to a plan – adhering to a mix of stocks, bonds and cash that makes sense for your age, wealth and future income needs.  It turns out that this mix (what we call investment policy), and your ability to manage it over your lifetime, overwhelming dictates the capital market return on your properly diversified portfolio.  This is because the historically volatile upswings and downdrafts of stocks tend to cancel each other out, producing the actual capital market return.  Adhering to an appropriate mix of assets tends to inoculate you from market volatility.

So, instead of making volatility your enemy –focus on techniques that turn it to your advantage (if not your friend).  One excellent technique is to dollar-cost-average savings into your portfolio over time.  Making consistent, ongoing purchases (such as participating in a 401(k) plan) guarantees that you will buy some shares when prices are low.

A second technique is to rebalance your portfolio at least once a year.  Rebalancing means buying or selling stocks to reach your predetermined, appropriate-to-your-situation mix of assets.  If stocks have climbed precipitously, then to rebalance, you would need to sell some of them in order to purchase bonds and cash.  This technique brings your portfolio’s balance of stocks and bonds back to a mix that is appropriate for you – effectively “selling high” and “buying low” which is much easier to do than the old adage of “buying low and selling high”!

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