5 Ways to Embrace Volatility

Investors may be better served to embrace the volatility of the stock market.

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I received an e-mail from a client the first week of July. He was concerned about the value of his accounts declining in May and June. While the account values had risen nicely in the prior twelve months, some of the gains had been given back.

The last part of his correspondence summarized many of the current headlines – unemployment was still high, consumer confidence was down in the latest poll and some economists were predicting a double-dip recession. He was asking, “What do I think we should do now?”

First, let me attempt to put this into context. The Dow Jones Industrial Average (DJIA) rose from a low of 6,547 on March 9, 2009 to 11,204 on April 23, 2010. That’s a gain of over 70 percent. However, nearly two months later – June 30, 2010 – the DJIA closed at 9,774, which prompted the client’s e-mail. Granted, that’s a decline of 12.7 percent from April 23, but it is also a gain of 49 percent from the March 9 low. Who would not be happy with a gain of 49 percent in 15 months? How can you conclude anything from two months of price movement in the stock market? What does any of this mean in regard to your long-term financial goals and financial well-being?

Most people do not like volatility. They equate volatility to risk and to a large extent, they are correct to do so. I’ve had people tell me they would rather have the relative certainty of a three-percent return from a certificate of deposit (CD) than invest in the stock market, where historic returns average close to 10 percent. Unfortunately, they ignore the fact that inflation has historically averaged four percent. All they’ve guaranteed is a reduction in volatility, not the success of their financial future.

Investors may be better served to embrace the volatility of the stock market. It’s the volatility that produces the 10-percent-average return. If stock prices were stable, the returns may not be as high. The investing profession calls this a “risk premium.” This simply means that if an investor is to put up with the volatility of his or her portfolio, that investor should be rewarded with a higher return (although there are no guarantees). It makes sense.

That doesn’t make it any easier to open your monthly statement and see the portfolio decline in value – that is, until you realize how little it means. It is not important to your long-term goals and it doesn’t tell you anything about the direction of the market in the future. For example, the DJIA reached a high of 14,164 on October 9, 2007. However, the value of your portfolio on that day is as meaningless as it was on the low day in March of last year – or for that matter, the value it is today.

Investors focus almost entirely on the total market value that appears on their monthly statements. Instead, they should focus on the sustained income potential of the portfolio over time. After all, hopefully you are never going to liquidate your entire portfolio on any given day. Those investments are there to provide an income – immediately if you are retired or at some point in the future when you plan to be retired. That income needs to increase each year to keep pace with inflation. This is why we may need stocks in our portfolio. You cannot retire with a 100-percent fixed portfolio and fight inflation.

By embracing volatility, you recognize that stocks are going to be consistently mis-priced. They will be overvalued during times of euphoria and undervalued when fear grips the public. A successful investor will recognize this truth about the market. He or she will also recognize that no one will ever be able to predict when this is going to happen.

“I was telling my colleagues the other day…I’d been dealing with these big mathematical models for forecasting the economy, and I’m looking at what’s going on the last few weeks and I say, ‘Y’know, if I could figure out a way to determine whether or not people are more fearful or changing to euphoric…I don’t need any of this other stuff. I could forecast the economy better than any way I know.

“The trouble is, we can’t figure that out. I’ve been in the forecasting business for 50 years and I’m no better than I ever was, and nobody else is either.”

Alan Greenspan, Former Federal Reserve Chairman
September 2007

In truth, successful investing does not rely on jumping in and out of the market. Success is having a long-term financial plan that includes a strategy to reach its goals. Some goals call for an allocation between fixed investments, like bonds and CDs, and growth investments (stocks). Volatility creates opportunities to implement your strategy. What follows are five things to do to embrace volatility and seek to take advantage of a stock-market correction:

1. Rebalance Your Portfolio

You will have too much money in fixed investments when the market goes down. This is the time to buy low. Sell fixed and buy stocks to rebalance back to the levels outlined in your strategy.

2. Convert an IRA to a Roth

Move tax-deferred assets to tax-free while the valuation is low. Anyone can do a Roth conversion this year regardless of income.

3. Pull Your Weeds

Time to get rid of underperforming positions that you may have been reluctant to sell because of tax implications. Upgrade your investment portfolio while prices are down.

4. Harvest Losses in Taxable Accounts

You may already have plenty of losses from 2008 and be thinking you can only take $3,000 each year on your tax return. However, losses can be used to offset capital gains in the future. Any losses will carry forward to future tax years – they never expire. You will be glad you have them when the market recovers.

5. Get a Second Opinion

Hire an independent financial adviser to review your plan and strategy. Be sure to get specific recommendations, what the strengths and weaknesses of your plan are, and the strategy you are using to implement it. (Read more tips on hiring a financial adviser.)

Remember that volatility may be your friend. Embrace it.

The information provided is general and educational in nature; it is not intended to be and should not be construed as investment, legal or tax advice. Federal tax laws, laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy or completeness of this information. Federal and state tax laws and regulations are complex and are subject to change. Rodgers & Associates makes no warranties with regard to the information or results obtained by its use and disclaims any liability arising out of your use of or reliance on the information. Consult an investment professional, attorney or tax adviser regarding your specific situation. Past performance is not indicative of future results. All investments carry the risk of loss, including loss of principal.

This article originally appeared in Lancaster County magazine.

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