Tuesday, May 5, 2009

Riding the Stock Market Roller Coaster

As the global economy continues to weaken due to lower corporate profits, higher unemployment and tight credit markets, the volatility in the stock market(s) should remain with us through 2009.

Last year was the most volatile market in the last two decades. There were 71 trading days in which the S&P500 moved up or down by more than 2%. Remarkably, 28 of those days experienced extreme volatility of 4% or more. By comparison, 2002 had six such days and 1987 experienced seven days. In the 4th quarter of 2008, three days had gains or losses of 9%. This has only happened twice since 1978!

So, volatility (or risk) is here to stay. At least for the foreseeable future as capital markets deleverage and re-evaluate the proper prices for stocks and bonds.

This can be unnerving... even paralyzing at times. But, volatility is a two way street. It can take stocks lower, but can also take stocks significantly higher. Positive annualized gains can often be contributed to a select few days in which markets soared. This is why most gurus and publications will preach 'stay the course'.

Asset Allocation: It is often said there are no free lunches. This is true in the financial world as well. But, there is one huge exception - Asset Allocation. While it doesn't work in every market environment (2008 to be exact), it has proven to work over time. A mixture of non-correlated assets... stocks/bonds/real estate/commodities... will diversify a portfolio and reduce account fluctuations.

Buy Low: Warren Buffet has often said, "Buy when people are fearful and sell when they're greedy." Great advice. However, the average investor will tend to do the opposite. Fear takes over and they make 'emotional' - as opposed to 'practical' - decisions.

A good example of why you should buy instead of sell during troubled times is evidenced in this March/April time frame. The Dow Jones Industrial Average (DJIA) seems to have bottomed in March at 6,500. While it's nearly impossible to predict the bottom in any market, there has been a significant recovery in the last two months. The DJIA is now 8,400 or 29% higher. Individuals who panicked and sold in March are certainly disappointed they didn't have staying power in hindsight. People who had the courage to follow Warren Buffet's advice have been well rewarded.

Rebalance: Portfolios should be rebalanced every now and then. Most experts would agree, once a year is appropriate. Many life cycle funds and asset allocation models have this feature built into the product. They automatically shift assets back to their original targets. If you started with a 60%/40% mixture of stocks and bonds, the account will automatically rebalance should the allocation change to say 70%/30% due to an increasing stock market.

Contrary to popular belief during turbulent times, 'rebalance' doesn't mean going from fully invested to a money market account. This all or nothing approach may seem logical at times, but often results in under performance over time. As fear sets in, this may seem like a logical decision. But, as I outlined above, investors who had the courage to add to their accounts when the DJIA was at 6,500 have outperformed any other asset class in that time frame - including money market accounts.

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