Coping with Investment Risk: A Survival Guide
The stock market’s recent volatility has left many investors feeling nervous. For almost three years the stock market has gone every way but up – and so, probably, has the value of your portfolio. What’s an investor to do?
It’s perfectly natural to be concerned when the value of your investments falls. But it’s also important to understand this simple truth: You cannot reasonably expect to reap the rewards of investing without also expecting to endure price fluctuations that can be both severe and unpredictable.
You can survive swings in the market by sticking to a carefully designed investment plan based on your personal situation and needs. Here are some tips:
- Don’t panic. If you sell at the first signs of trouble, you may miss out on big gains. Investors who sold all their stock holdings after the 1987 crash subsequently missed out on the market’s decade-long rally, which took the Dow from below 1,000 points to a record-high close near 12,000 in January 2000.
- Diversify your portfolio. Hold a mix of stocks, bonds, and cash investments tailored to your objectives, time horizon, risk tolerance, and overall financial situation. Cash investments, such as money market instruments, seek to protect the value of your savings and pay you interest regularly. Keep in mind, though, that inflation can consume most of your earnings. Bonds generally pay higher rates of interest, but they drop in value when interest rates rise. Stocks offer the best opportunity for long-term growth and protection from inflation, but short-term stock market risk can be very high.
- Balance risk and reward. To seek greater investment returns, you must be willing to assume greater risk – it’s an investment principle known as the risk/reward trade-off. Simply put, you must accept the fact that there will inevitably be periods when your stock and bond investments will decrease in value. During a bear market your stock investments could decline 20% or more.
- Continue investing regularly. Making regular contributions will put the market’s volatility to work for you by lowering the average price you pay for your fund shares over long periods. It also reduces the risk of committing substantial assets at a time when the market is considered “high.”
- Focus on the long term. It’s human nature to get nervous at the first sign of trouble and to want to revise your investment mix. Market downswings can cause even the most aggressive investors to have second thoughts, but it pays to remain focused on the long term. The markets run in irregular cycles, and good and bad periods come and go. Remember, too, you’re probably investing to achieve the long-term goal of retirement – not to avoid a short-term loss.
- Let time work for you. Time can be a great asset when coping with risk. A long-term view helps you overlook market downturns. You’ll usually find that taking some risk is worth it in the end. In fact, throughout every 20-year period since 1926, stocks have given investors better returns than more conservative choices.
- Don’t try to “time” the market. While rebalancing your portfolio once a year is a good idea, constantly shifting in and out of funds looking for top performance is not. The most successful investors are generally those who decide on an investment mix appropriate to their situation and then stay the course. Investment decisions based on short-term market fluctuations are usually emotional reactions that often lead to disappointing results.
- Set realistic expectations. Although stock returns were nothing short of extraordinary through much of the 1990s, stock performance has lagged in the past few years. Setting more reasonable expectations for your investment program may help you put market drops in perspective.
- Consider your overall portfolio. Don’t evaluate each fund you hold in isolation. Instead, think of your funds as playing distinct roles in your total portfolio, which includes your 401(k) plan and any other investments. Gains from one investment may help offset short-term losses in another, giving you a smoother overall performance and making it easier to weather the ups and downs of the market.
- Think “on paper.” If you don’t intend to spend your money in the near future, think of your losses as only “on paper.” Your investments should have plenty of time to bounce back with the markets. Remember, too, that if you are about to retire, you probably won’t need to spend all your money right away. So you can still afford to take some risk.
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