Investors don’t worry about all market fluctuations – just the type that reduces their portfolio values. No one seems shaken when the stock market shoots upward. But market volatility is price change, regardless of its direction. And when the market falls, many investors start questioning their portfolio mix. Here are a few common questions asked when the financial markets get active. Hopefully, the answers will help put the noise in perspective.
Q: “I can’t afford this market fluctuation. Where can I put my money for more stability?”
A: Market fluctuations are a normal course of investing. In fact, higher perceived risk is one reason why equities have historically offered a higher average annual return.
Investors rarely can have the best of both worlds. We face the ever-present trade-off of return and price stability. History says that short-term stability comes at the price of long-term performance. We should aim to assemble a portfolio that addresses various possible financial environments and one that matches your specific needs and goals. Volatility can be reduced by diversifying across several asset classes, including stocks, bonds, and cash. Once the appropriate mix is established, stick with it regardless of which financial environment materializes, making changes only when your personal goals and needs change, not in reaction to market ups and downs.
Q: “Why not move to cash or some other interest-paying investment?”
A: An interest-bearing investment serves a specific purpose. Stocks serve another. These purposes are considerably different.
Cash accounts are for short-term use, be it to cover sudden expenses or emergencies, or to meet anticipated bills like taxes, college tuition, and vacation. The amount set aside depends on your job security, financial circumstances, plans for the future, and comfort level. Most investors need to earn a return that exceeds inflation, and while cash is safe, it’s not an investment that offers a real, after-tax return.
Investors should expect something very different from long-term money. Planning for a large future expenditure like college tuition or planning for retirement years down the road creates a need for considerable growth. And growth in a long-term portfolio comes from stocks. Cash and bonds in a longer-term portfolio serve primarily to reduce the price fluctuations inherent in a portfolio of stocks.
Don’t confuse short-term money and long-term investments. And recognize the different roles of stocks versus bonds and cash in your long-term portfolio. When you shift from stocks to safer, less volatile assets, you give up growth potential.
Q: “International investing is hurting my returns. Why not focus on just the U.S. market?”
A: Because no major country’s stock market has stayed at the top or bottom for long. Investment markets move in cycles – and these cycles don’t move in lockstep.
It’s perfectly normal for U.S. investors to question the benefits of international diversification following several years of exceptional performance of equity markets here. However, the long-term prospects for equity returns from foreign stocks and U.S. stocks are comparable. And the next period of superior performance may come from foreign stocks.
Not all great stocks are found in the U.S., and companies based outside the U.S. make up nearly half of the value of stocks worldwide. Do you want to limit yourself to owning Ford or GM but not Toyota? Merck but not Novartis? P&G but not Unilever?
Having a mix of international and U.S. stocks has historically tamped down the volatility in portfolios. It’s natural to be concerned about geopolitical risk, but having a mix of U.S. and international stocks can actually reduce portfolio risk.
Q: “Why don’t we sit it out for now?”
A: Growth in the value of stocks occurs in spurts. No one has created a reliable system for consistently forecasting when these growth spurts will occur. It may be when stock prices seem extremely high; or when the economic outlook is at its bleakest; and sometimes when prices are fluctuating rapidly.
If you move to cash or other interest paying investments, you will miss any growth spurts that occur until you switch back. Remember that stock markets go up more often than they go down. So, if you choose to “sit it out,” you are likely to reduce your long-term investment return.
An interesting statistic from JP Morgan bears this out. In their study of the S&P 500 Total Return Index from January 3, 2000 through April 19, 2020, six of the seven best days occurred right after the worst day.
The temptation is great to move in and out of the market to avoid declines. Market timing requires two good calls, not just one: when to exit and when to re-enter. While you might make one good call, the odds of making two are low. And the psychology that drives you to leave the market means that you are unlikely to re-enter because you see the worst in the situation.
The problem is a practical one. No one has invented a crystal ball to help investors accurately predict the movements of the market.