The stock market has really been like a roller coaster lately with wide swings in prices each day. Worse yet, specific market sectors, such as technology stocks, have really taken it on the chin. What is a poor investor supposed to do these days? Hang tight, invest systematically, and stick with a game plan.
Below is some advice for nervous investors:
Realize that market volatility is normal. Among the causes recently are the increased flow of financial information to consumers (e.g., CNBC, the Internet), competition among mutual fund managers who are "chasing return" to keep their jobs; increased globalization and effects of the world economy; and a short term focus by many people who trade frequently.
Dollar-cost averaging is a recommended investment strategy. This means investing a regular amount at a regular time interval, such as $50 per month. Over time, the average cost of shares is reduced.
Another recommended strategy is diversification by investing in different industries and asset classes. An investment research firm called Callan Associates produces a brightly-colored chart that shows the annual return for various asset classes (e.g., small company stock, large company stocks, bonds, etc.). The message is clear: one year's top asset class can be next year's loser so you buy them all. Large company growth stocks, for example, topped the chart for four years in a row from 1995-1998 but were next to last in performance in 2000 with a minus 22.07% return.
Make sure that your mutual funds don't hold the same stocks. Otherwise, you won't have much diversification. A good reference tool for mutual fund decisions is Morningstar, available in the reference section of many public libraries. Avoid heavy concentration in specific market sectors (e.g., technology). This reduces an investor's diversification and increases their portfolio's volatility.
Some technology exposure is appropriate for almost everyone due to its' dominance in the U.S. economy. The specific percentage will depend on an investor's risk tolerance. Other industry sectors that are predicted to well in the future include health care, biotechnology, financial services, and real estate investment trusts (REITs).
Take the time to develop an asset allocation model for your portfolio. In other words, the percentage of their invested funds in different types of investments. Without a diversified portfolio, investors will give back a lot of their earnings during market downturns. On average, the stock market has three bad years per decade.
Investors should then "stay the course" and follow their model in both bull (rising) and bear (declining) markets. Rebalance back to the original weightings if these percentages change by a certain amount (e.g., 2%). Realize that successful investing in value stocks takes patience and time.
Investors should also carefully consider their risk tolerance level. Most people are more concerned about downside risk than upside earnings potential. Many mutual fund company Web sites have simple risk assessment tools. Think about possible losses in dollar figures, rather than percentages, when assessing your risk tolerance (e.g., losing $3,000 versus losing 9%).
Don't chase stocks or funds "after the fact." In 1999, many people got caught up in "dot com euphoria" without carefully researching their investments and lost big in 2000. Investors can use stop loss orders to put in some safeguards for their stock price gains.
The best advice for coping with investment volatility is to follow a disciplined investment strategy and do not deviate from it. Buy quality investments with below-average expenses (e.g., low expense ratios on mutual funds) and hold them. If you make exceptions to your plan once, you'll do it again.