Volatile markets can be unsettling. You work hard for your money and even losing money on paper, to market fluctuations, can make you want to put all your cash under the mattress. In reality most investments will have volatility. Fixed rate products like CD’s may not have volatility, but will have their own risk of not keeping up with inflation. Currently 1 year CD’s are paying around 1%, and 5 year CD’s are only paying around 2%, according to Bankrate. This makes it necessary to have investments in your portfolio, which will fluctuate in value, in order to potentially have the needed funds to pursue your financial goals.
With inflation averaging 3.22% per year from 1913 to 2013², it is easy to see that establishing an investment portfolio that provides higher returns than inflation is essential to any long term plan. Investors look to mitigate the risk of the volatile markets, while seeking a return that will build investment values.
For all its Bull and Bear markets, runs and crashes, stock market investments in the last 100 years has been positive when looking at any 10 year period from 1903 to December 1912³. The average stock market return since 1932 is around 7% and when inflation is taken into account the average return is over 10%⁴. So while the markets do go up and down on a daily basis, the overall market pattern has a consistent upward trend. However, past performance is not indicative of future results and your investments selection(s) and time horizon will affect your results.
Investing With Your Risk Tolerance in Mind
Investment risk, by definition, is the likelihood of losses in relation to an expected rate of return for a specific investment. All investments have some investment risk. The challenge for you is to determine which investments have risks you are willing to accept, and may be potentially rewarded with higher returns on a consistent enough basis.
This is where a Sherman Wealth Management financial professional comes in. They work with you to determine a level of risk that is suitable for you and provide the potential growth needed to pursue your financial objectives. This requires not only understanding specific investments but also having a good pulse on what you, as an investor, need.
In order to give the best advice, it is necessary to truly understand the client’s needs. Just asking, how much risk are you comfortable with, is not enough. Educating and teaching you about risk and what it may mean for your future, is the goal. This allows you to select investments that reflect your risk tolerance and financial aspirations.
Taking a high level of personal interest in the changing needs of our clients is our goal. We believe this is the best strategy for maintaining an investment portfolio that is designed to have the appropriate amount of risk to pursue your financial goals, while striving to minimize the risk taken on individual investment choices.
Each investor has individual needs and no investor’s taste for risk is the same. You need recommendations that take all of your circumstances and life goals into account. Added risk might lead to higher returns, but not always.
If you have a lower tolerance for risk, building an investment portfolio that is designed to withstand market turmoil is more appropriate. These strategies still experience ups and downs, but the right blend of investments potentially moderate the fluctuations to align with your tolerance for risk.
The stock market offers investments that carry various levels of risk. There are value, dividend paying stocks that have a lower volatility than emerging small cap stocks. Bonds are also available at various risk levels, allowing you to manage risk and performance within the portfolio.
Asset Allocation for Mitigating Volatility
Another method to help mitigate market risk and volatility is through Asset Allocation. This is the process of using several asset classes within an investment portfolio by apportioning a portfolio’s assets according to the individual goals, risk tolerance and investment horizon. Stock market investments have the general categories of stocks and bonds.
Stocks are broken down further between value stocks and growth stocks, with value generally being more conservative. Stocks that pay dividends are usually more conservative than stocks that do not, because investors are getting some return while they still hold the position. Stocks are also broken down by company size. These are denoted as large cap, mid cap and small cap stocks. Large cap stocks include companies like Microsoft, Apple, Bank of America and national names we all recognize. Small cap companies are those with 300 million to 2 billion in revenue, and mid-caps are between these two. The last large category is US companies and International or global companies.
Bonds are rated much like individual credit is rated. There are consumers that are a much lower risk than others and this is measured through individual credit scores. Bonds operate in a similar way. There are independent credit agencies like S&P and, Moody’s which rate company bond offerings. Bond ratings are expressed as letters ranging from ‘AAA‘, which is the highest grade, to ‘C’ (“junk“), which is the lowest grade. Different rating services use the same letter grades, but use various combinations of upper- and lower-case letters to differentiate themselves. Lower ratings represent higher default risk and thus higher interest rates to investors.
Selecting the best mix of stocks and bonds is a delicate balance. Spreading your investments choices across different categories may provide an effective way to reduce the overall volatility of a portfolio. As the market fluctuates not all stocks and bonds move up and down at the same rate or the same time. When asset allocation is used correctly there is a designed buffer against losses and the overall risk of the portfolio should be reduced.
Advantages of Dollar Cost Averaging
Dollar cost averaging is an investment strategy where you invest a fixed dollar amount on a regular schedule, regardless of the actual price of the stock, bond or other investment vehicle. There are several advantages to using this strategy.
Smaller amounts can be invested providing potential benefits of growth over time. Time in the market is much more important than market timing and dollar cost averaging gets you in the market on a regular basis.
Buying more shares when the stock has a lower price and less shares when the price is higher. . Even the best companies will see stock prices fluctuate based on a current news reports, events that impacts the industry, or seasonal fluctuations.
Dollar cost averaging helps reduce the risk of the overall portfolio because you are investing at regular intervals and buying more shares when the prices are low. This can be an effective way to grow your portfolio. Studies have shown that those who invest in regular intervals are more consistent with their investments, providing better overall growth, according to Morningstar⁵.
Dollar cost averaging does not protect against a loss in declining markets. Since such a plan involves continuous investments in securities regardless of the fluctuating price levels, the investor should consider his or her financial ability to continue such purchases through period of low price levels.
Financial strategies require a long term strategy. As such, volatility must be considered in your investment choices. Avoiding volatility because of fear can result in negative returns, when adding the impact of inflation. Working with a financial professional who understands volatility and uses strategies designed to enable you to build a portfolio which is suitable to your risk tolerance. Let us help you determine which investments are appropriate for your financial goals.
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Related Reading:
Tips for Millennials to Understanding the Stock Market
What is Dollar Cost Averaging?
5 Big Picture Things Many Investors Don’t Do
Why and How to Get Started Investing Today
The Psychology of Investing
Rebalance Your Portfolio to Stay on Track With Investments
Behavioral Investing: Men are from Mars and Women are from Venus!
Footnotes:
1. http://www.bankrate.com/cd.aspx and http://www.nerdwallet.com/rates/cds/best-cd-rates.
2. http://inflationdata.com/Inflation/Inflation_Rate/Long_Term_Inflation.asp
3. https://www.efficient.com/pdfs/A_Century_of_Evidence_on_Trend-Following_Investing.pdf
4. http://observationsandnotes.blogspot.com/2009/03/average-annual-stock-market-return.html
5. http://www.morningstar.com/InvGlossary/automatic_investment_plan.aspx
