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May 2008
"Housing Crisis," "Recession," "Credit Crisis," "Subprime Loans" ... media buzz words that are pretty hard to ignore as they are a major part of many news stories. Needless to say, the last couple months have been pretty rough for investors. Unfortunately, some people are reacting to market volatility emotionally rather than rationally. It is important to remember at these times of declining stock prices and market volatility that fluctuations in the stock market are normal. For investors who maintain a "cool head," volatility can present an opportunity rather than a cause for concern. Consider the following suggestions from the Office of Financial Success at the University of Missouri-Columbia:
Avoid Emotional Decisions - When people read about historical stock market returns (i.e., the S&P 500 average return of 10.3% per year over the past 80 years), many people envision a scenario where they will earn a 10% return every year. Wouldn't that be nice! Amazingly, during those 80 years, on only 6 occasions did the market return the annual average plus or minus 3% (i.e., an annual return between 7.3% and 13.3%). In other words, volatility is a normal part of investing ... Investing automatically every month (in up and down markets) is one of the easiest ways to avoid the risk of emotional investing.
Avoid the Urge to Micromanage - Lots of people have the urge to constantly watch the market. This can easily lead to irrational action. A bad day in the market emotionally feels much worse to people than a good day in the market feels good. Looking at stock prices daily also makes it much more challenging to maintain a long-term perspective.
Consult Others - There are a lot of resources (e.g., Internet, financial professionals, etc.) available to assist investors. Don't feel like you need to do everything on your own unless you feel comfortable doing so. Get a financial "check up" where someone else can take a look at what you're doing with your money and offer recommendations. Plenty of smart people seek the advice of others. You've probably read studies where everyone believes they are "above average" drivers. Obviously, everyone isn't. Similar studies find that investors tend to overrate their skills and knowledge.
Establish a Cushion - In volatile investment markets and economic downturns, the value of an emergency fund becomes very apparent to hedge unexpected events such as the loss of a job. It is wise to have a cushion of income to cover 2 to 3 months worth of expenses in a "secure" (no risk) account so that, if you need money, you aren't forced to sell assets to meet short-term needs.
Diversify - Spreading your investments among various types of asset classes and U.S. and non-U.S. securities, etc. won't necessarily keep your account from losing value in a down market, but it can help to temper losses. Diversification should be a key part of your investment strategy.
Maintain Perspective - Obviously this is easier said than done... For individuals with a long-term horizon, keep in mind that there has never been any 15 year time frame between 1926 and 2006 when the stock market has lost value.
Stick to Your Strategy - Hopefully you had a rational justification for developing your investment strategy. If so, the key is to stick with that strategy through the ups and downs of the market. Trying to "time" the market (particularly during high levels of volatility) is not a smart move. During the 10 years from 1/1/97 to 12/31/06, despite a lot of market volatility, the S&P 500 returned an average annual return of 8.4%. If you had missed the ten best stock trading days during that time, you would have earned 38% less money; and if you had missed the twenty best days, you actually would have lost money!
Understand the Risks Involved - Past performance may be comforting, but there is no guarantee of anything in the world of investing. Risk is real. Understand those risks prior to investing money. Use turbulent times as an opportunity to better understand risk, asset allocation, and other important aspects of investing so that you can avoid making future costly mistakes. Now is the time to educate yourself, not the time to emotionally react.
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