Q: My partner and I have seen the balances on our investment statements go up and down quite a bit these past few months, which makes us a bit uncomfortable. We are wondering if we’re invested too aggressively.
A: Many investors would have seen some volatility on their statements these past few months, so you’re certainly not alone. The first question I would ask you is: Why are you investing in the first place? Is it for a longer-term objective such as retirement, or something very short-term such as buying a new home this year? Once we understand the objective, then you can better match your investments and risk level appropriately.
For investors accustomed to strong and consistent stock-market gains, a period of sustained falling stock prices is not easy to accept. All too often, investors will react to a drop in prices by panic selling or digging their heels in, despite deteriorating fundamentals. But more thoughtful investors will see a correction or downturn as an opportunity to review their portfolios and make adjustments where necessary.
A stock-market correction is defined as a time when major market indexes drop between 10-20 percent. Declines greater than 20 percent are considered to be bear markets. If confronted with a significant market decline, how might your portfolio be affected? Here’s a short list of some potential risks you may face as an investor in stocks, and some ideas about how to potentially reduce the chance of your portfolio suffering a big loss.1
Market risk, common to all types of investments, is the possibility that an investor will experience losses due to factors that affect the overall performance of the financial markets. You can potentially manage the impact of market risk on the stocks you hold by allocating part of your portfolio to other types of assets, such as bonds.2 In this way, when stock prices decline, it’s possible that a rise in your bond investments will help cushion the fall.
Lack of diversification.3 If you only own a couple of stocks, you are extremely vulnerable if one suffers a major decline. For this reason, experts recommend that stock investors hold more than a handful of stocks. That way, if one stock falls sharply, the drop may have a more limited influence on your overall portfolio. Also, it’s important to diversify your stock portfolio among various industry sectors. For instance, owning just computer-related stocks will do you little good if the prospects dim for the computer industry. Keep in mind that diversification does not protect an investor from potential loss.
Volatility, or the degree of variation of returns over time for a particular security or market index, is a consideration, but it generally is not as important to an investor with a long-term time horizon. For instance, someone who is investing for retirement in 30 years should not be too concerned if an investment bounces around from one day to the next. What is important is that the investment continues to perform up to expectations. You can potentially manage the effects of volatility by investing the money you may need in the short term (within five years or so) in a more conservative investment, while choosing to be more aggressive with the money you have earmarked for use in 15-20 years.
Liquidity risk is the risk that a given security cannot be traded quickly enough in the market to avoid a loss or to achieve the desired profit. If you invest in a stock that “trades by appointment only,” you may get a low price if you are forced to sell the issue on short notice. You may be able to reduce liquidity risk by focusing on large, actively traded companies such as those included in the S&P 500.4
Finally, one sometimes-overlooked risk is that of falling short of reaching a long-term financial goal. Investing too conservatively may contribute to not reaching an accumulation target. Remember that despite several down cycles, stock prices have historically risen over longer time periods. Past performance, however, does not guarantee future results.
A healthy market decline
It’s important to remember that periods of falling prices are a natural and healthy part of investing in the stock market. While professional investors may use a variety of trading tools to hedge their portfolios against a sudden drop in the market, perhaps the best move you can make is managing your overall exposure to the risks discussed above.
Now that it’s the beginning of a new year, it’s probably a good time for you to contact your financial advisor to review your portfolio to be sure you’re properly positioned for whatever lies ahead.
Also, a reminder from our December 2015 column on Social Security:
Social Security Workshop
To help our LGBT baby boomers better understand how recent legislation may impact your Social Security strategy, our friends at the Delaware Valley Legacy Fund and I will be hosting a free educational workshop on Social Security planning. If you will be filing for your Social Security benefits in the upcoming months and years, I encourage you to join us to better understand how to make the most of your Social Security benefits.
*As reported by Financial Planning magazine, 1996-2015, based on total revenues.
**Award based on 10 objective criteria associated with providing quality services to clients such as credentials, experience, and assets under management among other factors. Wealth managers do not pay a fee to be considered or placed on the final list of Five Star Wealth Managers.
1Investing in stocks involves risks, including loss of principal.
2Bonds are subject to market and interest-rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
3There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.
4Standard & Poor’s Composite Index of 500 Stocks is an unmanaged index that is generally considered representative of the U.S. stock market. It is not possible to invest directly in an index. Past performance is not a guarantee of future results.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This article was prepared with the assistance of Wealth Management Systems Inc. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with a qualified tax or legal advisor. Please consult me if you have any questions.
Because of the possibility of human or mechanical error by Wealth Management Systems Inc. or its sources, neither Wealth Management Systems Inc. nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall Wealth Management Systems Inc. be liable for any indirect, special or consequential damages in connection with subscribers’ or others’ use of the content.
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