Investors are not very good at handling market downturns. Research has shown that we feel the pain associated with investment losses more acutely than the pleasure of gains. Our ability to stick to a carefully considered investment plan deteriorates as losses mount and perhaps most dangerously, our reactions lag economic reality (see graph below). Consider that just before the 2008 financial crisis, 90% of individual investors thought that stocks were the best investment. The prospect of rising interest rates, slowing economic growth and heightened market volatility now has investors questioning their carefully laid out investment strategies. Before making any adjustments consider the following points.
Remember Why You Diversify: Diversification is an investor’s best protection against uncertainty. While the financial press is full of market forecasts (see Julie’s article on page 3), we cannot know for certain which asset class or economic sector will outperform next. The remedy in this uncertain environment is to spread your bets widely and be sure to not overpay. A well diversified portfolio should include stocks (both U.S. and international), bonds, and cash. Research shows that small exposures to real estate and commodities can also help over long periods of time. Getting the asset allocation (mix between stocks, bonds and cash) decision right requires careful thought and a healthy dose of self-knowledge. Recognize that you are likely to overestimate your ability to withstand losses in good times and plan accordingly. Finally, remember that if you do not have an underperforming portion of your portfolio, you probably are not fully diversified.
Resist the Temptation to Chase Winners and Sell Losers: If an investment is going up in price, investors want to jump on board and if it is going down, they want to sell. But this emotional reaction runs completely counter to the oldest of investment maxims: buy low and sell high. Today, for example, investors are fleeing emerging market stocks. True, we cannot know for certain when they will rebound but as the chart above shows, valuation levels in these markets are increasingly attractive.
While we are not big believers in the value of market forecasts, except perhaps as contrary indicators, we do think there are solid reasons to believe that financial market returns over the next 5-10 years will be lower than they have been in past periods. Modest corporate profit growth and ample valuations levels are likely to hold stock returns back going forward while the current low level of interest rates across the globe are likely to temper bond returns. The implication here?
Control What You Can: Investors cannot control the financial markets but they can control a number of things that have an even bigger impact on their long term financial well being. These include maintaining an adequate emergency reserve fund. While situations vary, many financial advisors recommend investors holding anywhere between 6 months and 1 year’s worth of living expenses in cash. These funds should be placed in safe and secure investments such as a money market fund or FDIC insured CDs. This cash cushion will not only help cover expenses if the unexpected occurs but will also help you hold firm when your other investments experience volatility. If you have dependents, make sure you own life insurance. Nothing fancy required here, a low cost term policy is usually sufficient. If you are still working, contribute regularly to a retirement plan and finally, and perhaps the hardest of all, live within your means.