Q: In these uncertain times it’s a little hard to know how to manage our retirement savings. Is there anything that we should be doing different? If so, what do we change?
A: In August and September of 2011, there were some episodes of volatility present in the stock market; the likes of which we haven’t seen since 2008/2009. These were, for a large part, due to three specific events: the European debt crisis (which just doesn’t seem to want to go away), the political issues that surrounded the debt ceiling and finally the downgrade of the U.S. debt.
These bouts of volatility are often followed by a rash of media coverage. This is often accompanied by your average investor wondering what they should do, if anything. Some people will begin to shift their portfolios while others will simply stay the course. Which action is correct? To help determine the answer, let’s take a look at four topics.
Perception vs. Reality The media often makes it appear as if during turbulent times, investors are entirely selling out of one area and jumping into another. While there may be individual investors reacting and moving out of equities and into fixed income or money markets, when we look at the statistics and data, we see that the vast majority of investors stay the course.
Behavioral Finance This field of study combines psychology and economics in an attempt to explain why and how investors act and to analyze how that behavior affects the markets. Behavioral finance theorists point to the market phenomenon of hot stocks and bubbles to validate their position that market prices can be affected by the irrational behavior of investors. What this means in short is, when the markets move around or act in an irrational manner (read volatile), individuals tend to respond accordingly. This may not be the right course of action, but it happens.
Maintain A Sense Of Balance One of the best things to do in volatile times is to maintain a balanced portfolio. Sounds too simple right? The reality is that it works. According to Fran Kinniry of the Vanguard Investment Strategy Group “even from the peak of the market, a balanced investor is still positive. And when I say, “balanced,” I mean someone who has a combination of equity investments and fixed income investments.”
For those who struggle with this from an individual standpoint, let’s take a look at it from the market perspective. Let’s say you have $1,000 that represents all of the investment money in the economy. Then there are three pails on a set of scales, which represent the sectors that can be invested in (stocks, bonds and cash instruments). We can put the money into any pail we choose, but the equilibrium between the others will change. What this means is that one area will make money while another loses it. Yet one thing will remain unchanged, the amount of money in the market.
Thus, ones best bet is to spread the money around so that when you lose a little in one area, you’ll gain it back in another (and as a whole you shouldn’t be impacted too much). The problems arise when all of your eggs are in one basket, such as when you are nearing retirement. If everything you have is in stocks or bonds and the market goes through a prolonged period of adjustment, you may not be able to react fast enough to save your nest egg from severe losses. Thus, a little asset reallocation may give you that level of protection that you need.
Calculated Market Exploitation Maintaining a balanced portfolio doesn’t mean that you ignore trends or where the money is being made. However, what an investor should strive to do is indentify the trends, but don’t attempt to bet the house and ride a wave. By the time an investor decides to jump into an area that is “hot” or appears to be making money, the reality is that all of the “real” money has been made. What will remain are the speculators and more often than not, these will be the people who get burned when the market can no longer sustain the inflated prices.
A slightly more realistic approach would be to take a portion of your portfolio (that you won’t miss if things go south) and put it into a general area that encompasses the trend. For example, gas prices don’t look to be falling anytime soon. With that said, investing in an exchange-traded fund (ETF) that deals with energy might be a nice hedge in your portfolio. Energy will probably always make some money and we all know that these companies tend to pay out dividends. So while you’re not betting on a specific company or stock, you are inadvertently benefiting from investor and market trends.