Asset Management

Coping with market volatility: TIAA-CREF offers five considerations for investors

TIAA-CREF Investment Insights

Dramatic changes in financial markets – particularly steep drops in stock prices – may cause you to question whether your investments still meet your needs. Many investors wonder how market volatility will impact their financial goals, such as funding retirement, college education, or a home purchase.

Sudden market changes can be an opportunity to reassess whether you have the right mix of investments to achieve your goals, while tolerating the market’s inevitable ups and downs. As a general rule, it’s better to avoid making abrupt changes to your investment strategy in response to short-term market shifts. Remember, selling during a downturn will lock in losses and could mean missing an eventual market upturn.

Article Highlights

  1. Have a Financial Plan and Strategy
  2. Learn from Bear Markets
  3. Diversify your Portfolio
  4. Avoid Market Jumping
  5. Do Periodic Rebalancing

Here are five things to consider when confronting market volatility:

1. Do you have the right financial plan and investment strategy?

  • Benefits of a financial plan. A well-thought-out financial plan and investment strategy can help to provide the confidence needed to cope with market volatility. A financial plan should provide a clear roadmap for achieving a range of goals – from paying monthly rent or mortgage and saving for college, to investing for retirement. The plan should address your budget – how much you can afford to spend on living expenses – and how much you need to save to achieve your most important goals. A long-term plan may help you ride out the market’s short-term volatility, reducing worry and pressure to react.
  • The right mix of investments. Your investment strategy should include an asset allocation – or mix of investments – that matches your financial goals and risk tolerance. To help manage risk, you should consider diversifying your portfolio with different types of investments, including stocks, bonds, and possibly other investments, such as real estate and guaranteed investments. Bottom line: Stocks may help to address the long-term risks of inflation and outliving your savings in retirement. And income-producing investments, such as bonds, may help temper market volatility and meet income needs in retirement.
  • Benefits of an emergency fund. It’s important to maintain an emergency fund in very safe investments, such as bank deposits or money market funds1. Keeping funds on hand to meet near-term expenses could help you stay the course with riskier investments, such as stocks and bonds, over the long term.

2. Lessons from the bear market of 2008-2009

  • What investors learned. Important lessons from the bear market of 2008-2009 can help investors cope with recurring bouts of market volatility: 1) Your asset allocation – or mix of investments – must match your tolerance for risk. 2) Selling in response to the market crash locked in losses, while staying the course helped investors recoup most of their losses over time. 3) Periodic market corrections have provided profitable buying opportunities.
  • Develop the right strategy and stick to it. Many investors who felt compelled to sell during the downturn discovered that their asset allocation was too aggressive for their risk tolerance. For a long-tem investment strategy to work, you must be able to stick with it. If you feel that market volatility is jeopardizing your financial goals, it may be time to consider adjusting your investment mix for a better balance of risk and return.
  • Staying the course helped recoup losses after the last bear market. Investors who sold near the bottom of the 2008-2009 bear market locked in steep losses. The market plunged 43% from its peak in October 2007 to its trough in March 2009, based on the Russell 3000® Index2 a proxy for the U.S. stock market. Investors who stayed the course benefited from the market’s strong rebound, recouping about 97% of their losses by April 2011. Investors in diversified portfolios could have done even better, potentially recouping all their losses and showing gains because other asset classes, such as bonds, had gains or smaller losses than stocks. (The Barclays Capital U.S. Aggregate Bond Index, for example, gained 5% during the same period between 2007 and 2009 when stocks plunged.) Since its 2011 high, the stock market has tumbled 14% as of August 11, based on the Russell 3000 Index. Although the market’s future direction is impossible to predict, past experience illustrates the benefits of staying the course, rather than reacting to sudden market shifts.

Coping with market volatility: Lessons From the Bear Market of 2

3. Diversification3 can help protect your portfolio from market volatility.

  • Diversification defined. Diversification means owning different types of investments, rather than being concentrated in only one or two. Examples include U.S. and international stocks, bonds, real estate, and guaranteed investments. It also means owning different types of stocks, such as large, medium, and small companies, and various kinds of bonds, such as Treasury, corporate, asset-backed, and mortgage bonds.
  • Managing risk. Diversification can help manage risk because different types of investments tend to rise and fall at different times or to different degrees. Since it’s impossible to predict which investments will perform better at different times, keeping a broad range in your portfolio can be beneficial. When stocks are going down, for example, bonds that produce steady income can help to reduce losses in your portfolio. Even if all types of investments are falling – as during the last bear market – having the right asset allocation and sticking with your plan may be the best approach.
  • Higher returns with lower risk over time. The chart below illustrates the benefits of diversification, based on market returns between 1970 and 2010. Although bonds are generally safer than stocks, the 100% bond portfolio had higher volatility and lower returns than portfolios containing a mix of stocks and bonds. The lowest-risk portfolio consisted of 28% stocks and 72% bonds, and provided higher returns than the all-bond portfolio. Even a portfolio of 50% stocks and 50% bonds had lower risk, while earning significantly higher returns, compared with the 100% bond portfolio.

Coping with market volatility: Benefits of Diversification Chart

4. Market timing – jumping in and out of the market – is a losing strategy.

  • Markets are unpredictable. It’s important to have a long-term investment strategy that doesn’t change with market movements for one reason: The market’s ups and downs are impossible to predict. Studies show that trying to time the market – by moving in and out of investments – is a losing strategy over the long term. Inevitably, most investors end up buying and selling at the wrong times, producing much worse performance than if they had simply stayed in the market.
  • Chasing performance. When investors try to time the market, they usually wind up chasing performance. They tend to buy after an investment has already gone up and tend to sell after the investment has gone down. The resulting pattern of buying high and selling low can destroy long-term performance.
  • Market timing destroys returns. A study by Dalbar, Inc. showed the average stock mutual fund investor earned a return of only 3.83%, or less than half the S&P 500® Index return of 9.14%, for the 20-year period 1991 through 2010. Similarly, the average investor in bond mutual funds earned only 1.01%, a fraction of the 6.89% return for the Barclays Capital U.S. Aggregate Bond Index. The reason: poor timing that tended to miss market gains and lock in losses, sharply reducing returns.

Coping with market volatility: Market Timing and Chasing Fund Performance Chart

5. Periodic rebalancing4 helps you to stick with your long-term investment strategy.

  • Keep your portfolio in balance. Rebalancing your portfolio periodically can help to maintain the right proportions of different investments, correcting for market movements. Unless you rebalance, investments that perform better over time will represent a larger proportion of your portfolio. And investments performing less well will represent a smaller proportion. As a result, your mix of investments can shift from the mix representing your long-term strategy, potentially hurting performance and increasing risk.
  • Rebalance to help you buy low and sell high. Rebalancing is a valuable discipline that forces you to sell investments that have run up in value and buy investments that have fallen. Making these adjustments by selling high and buying low maintains your chosen strategy, while helping to reduce risk.
  • Rebalance periodically. Experts recommend rebalancing your portfolio when its composition no longer matches your long-term investment strategy. The goal is to restore the predetermined percentages for stocks, bonds, and other investments. Rebalancing after stocks have fallen, for example, would involve buying stocks at lower prices and selling other investments that outperformed stocks.

Coping with market volatility: Rebalancing Helps Maintain Your Investment Strategy Chart

The information provided herein is as of August 11, 2011.

TIAA-CREF NEWS ARCHIVE

C521