*Articles and content provided by SigFig Wealth Management, LLC.
The stock market has had a shaky start of the year, with the Dow Jones Industrial Average registering triple-digit drops or gains on seven out of the first 10 days of trading in 2015. On days like these, it can be tempting to act on emotions. But doing that can be costly.
Research shows that investors who trade more frequently earn lower returns. In fact, while investors had a median 4.3% return in 2014, according to data from investment firm SigFig, frequent traders — those with 100% or higher portfolio turnover, which amounts to selling all of your portfolio holdings and buying new ones — had a median return of just 0.1%. (The other extreme – portfolio neglect, or less than 1% turnover, isn’t so great either: those folks’ investments earned a median of 2%.)
“The people who really get burned are the people who try to make a lot of trades and time the market on a daily basis,” says Derek Gabrielsen, wealth advisor with Strategic Wealth Partners. “Those people are going to lag behind.”
Consider this: When news of the first case of Ebola on American soil broke, pundits were predicting a huge decline in the stock markets. In the 10 days from Oct 6, 2014 to Oct 15, 2014, the S&P 500 fell 5.4%. But guess what happened a couple of weeks later: the index had recouped all losses and was back up 7.6%, to 2,018.05 by Oct 31.
The S&P 500 dropped 5.4% between October 6 and October 15, 2014, but bounced back and recouped all losses by the end of the month.
Keeping emotions in check is easier said than done in a volatile market, but it’s not impossible. Here are three ways to handle market volatility:
Budget for risk
We don’t think twice about creating a household budget for mortgages, bills and discretionary spending, but budgeting isn’t a strategy often associated with investing.
That means taking the time to figure out a dollar amount of loss you can stand. For instance, some investors might be able to stomach their portfolios dropping $500 in one month, but if in the next month the unrealized losses have increased beyond their comfort zone, that’s a sign they should re-evaluate the amount of risk they have in their current investment strategy, says Judith Lu, partner and managing director at Miracle Mile Advisors. “It’s important to remember that when looking at the value of your portfolio and the unrealized losses (and gains), they are still unrealized. It is a snapshot of a moment in time only,” she says. “By selling at that moment, you now realize those losses and effectively take away the chance to reverse them. That is what leads many people to buy high and sell low.”
Diversify to prevent losses
One common investing mistake is having all your eggs in one basket. Many investors bet a large portion of their portfolios on one stock — and if that stock plummets, so does the value of their portfolio. One in four investors, in fact, hold more than 23% of their portfolios in a single stock, according to SigFig research. Keep in mind, that doesn’t account for potentially increasing that exposure further if those investors’ mutual funds hold the same stock.
“Investors still have a bad habit of overweighting everything U.S. large cap,” says Timothy Speiss, personal wealth advisor at EisnerAmper. Instead, they should make sure they are diversified not only across multiple asset classes, but diversifywithin each asset class, as well.
Half of the investors who use SigFig’s portfolio tracker, for example, have less than 3% of their portfolios in international stocks. And since U.S. equity market capitalization is 35%-45% of total worldwide stock capitalization, that range should be an appropriate weighting of an investor’s equity allocation — suggesting that the majority of investors are significantly underexposed to international stocks.
Have a plan and stay the course
Making money in the stock market is about more than just choosing a handful of stocks and buying and selling based on price movements. It requires you to set a time horizon, prepare a plan based on your risk tolerance, and stick to that plan. “You need to know what each investment in your plan is supposed to do,” says Gabrielsen. “Part of that is figuring out how much you need in the way of returns.” Equally important, says Gabrielsen, is your time horizon. The longer your time horizon, the less (if at all) you should be panicking about the day-to-day fluctuations of the market. “While you can’t ignore things, you always need to have blinders,” says Gabrielsen. “If you are diversified and your portfolio is properly positioned for the return you need over a long period of time, you will be fine.”