“Diet and exercise. Diet and exercise!” This is what I keep hearing when I visit the doctor or read an article about staying healthy or dropping a few pounds. Even the attention-grabbing advertisements for the latest and greatest new weight loss pills end with a disclosure about their “effectiveness in conjunction with diet and exercise.”
I suppose I’ll have to take that advice while I wait for the next miracle drug. The prescription for handling stock market volatility is probably familiar to you as well. Instead of “diet and exercise” it is “patience and diversification.”
The equity markets, in the U.S. and abroad, have begun the year with significant volatility. Concerns about the Federal Reserve Bank raising interest rates, the drop in oil prices and slowing growth in China have led the S&P 500 Index to its worst January start in history. While it may not be new advice, the best advice for long-term investors is to be patient and to ensure you have a diversified portfolio. Let’s take a closer look at each.
To be clear, being patient doesn’t mean ignore your investment portfolio. I believe you should always know where your money is invested and how it’s performing. But you should not always react, especially by selling when you see a drop in the value of your portfolio. This is when patience is virtuous.
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Over the last 15 years, the S&P 500 Index, a common measure of the US stock market, has had an average annual return of about 5%. While the historical return of the Index is almost twice that, the last 15 years have included two of the worst equity markets in history. During this time period the S&P Index had a low yearly return of -37% in 2008 and high yearly return of 32.4% in 2013. If an investor were to panic and sell after 2008, he could suffer a huge loss. Patience would have allowed the investor to reap the benefits of higher returns in the years following the large loss.
Having all of your portfolio invested in the S&P 500 Index--or any single index for that matter--is not wise. Recovering from a total return of -37% is difficult and takes time. If you’re approaching retirement you may not have the time to make up a portfolio loss of that magnitude. This is where diversification can help. Many times when one area of the stock market is doing poorly, another may be doing well. Having part of your portfolio perform positively when another part is performing negatively will eliminate the sharp declines in overall portfolio value.
Diversification involves spreading your investment dollars over multiple asset classes. Instead of just investing in U.S. stocks, a diversified investment portfolio may include cash, bonds--both U.S. bonds and foreign bonds--international stocks, real-estate, commodities and other asset classes. The proper mix of different asset classes, which are actively managed and re-balanced, can add return and reduce risk in an investment portfolio.
The presence of bonds has historically added safety to portfolios. Bonds typically pay interest so there’s a positive return coming back to the portfolio at all times. Bonds also mature at face value so the bondholder is guaranteed, by the issuer, to receive his original investment back. These factors contribute to the safety of bonds and make them a desirable complement to stocks in a portfolio.
While it may not be new news, patience and diversification can be the right prescription for the long-term investor to deal with market volatility.
Chris Walden, CFP®, is an advisor with Heartland Capital Advisors, LLC, a registered investment advisor in Independence, MO.
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