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| How to Cope With Ongoing Market Volatility |
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After an extremely volatile finish to last year, investors hoped to see a return to the relative tranquility that marked the financial markets of early 2007. Thus far, just the opposite has occurred—causing many investors to wonder what's in store ahead.
The market's continued gyrations are being fueled by ongoing housing weakness, continued fallout from the subprime mortgage market, and fears the U.S. economy may be headed toward a recession.
The Federal Reserve Board (the "Fed") has responded to the strains on the economy by aggressively lowering short-term interest rates to stimulate growth. While in February the Fed reduced its outlook for GDP growth in 2008 to 1.3%-2.0% (down from 1.8%-2.5%), it does not foresee a recession and indicated that additional rate cuts could be forthcoming if necessary. MainStay Investments Chief Investment Strategist, William Knapp, Ph.D., also believes1 the U.S. economy can stave off a recession. This forecast is based on his belief that "wary consumers will become more confident in the months ahead due to significant mortgage refinancing activity, lower gas prices, and the government's economic stimulus package."
What Does Market Volatility Mean for You?
Until the uncertainty surrounding the economy dissipates, it's likely that we'll continue to experience periods of volatility in the financial markets.
How can you cope with such an environment? Perhaps the best advice is to remain focused on your long-term financial goals. While market volatility is unsettling, it's a natural occurrence and it can lead to significant opportunities for investors who maintain a long-term perspective. As you can see in the chart below, volatility has a significant impact over shorter time periods. However, the longer you hold your stock portfolio, the less volatility affects it, and the more likely you'll realize positive results.
Don't Try to Hit a Moving Target
Market volatility can also serve as a wake-up call. Even long-term investors need to periodically review their portfolio with their financial advisor to insure that it's appropriate given their goals and risk tolerance. A key component of a portfolio review is to be sure it is adequately diversified. That's because investment performance is a moving target. As you can see in the table below, while one asset class may be a star performer one year, it can fall to the bottom of the pack the very next year. Given this dynamic, it's essential to maintain a portfolio that is diversified across a wide variety of asset classes and investment styles.
Diversification in Action
A great way to see the power of diversification in action is through the following hypothetical "tale of three investors." Mary and her two brothers John and Bill were introduced to their parents' financial advisor to discuss their long-term financial goals. By the end of the discussion, they each agreed to open an account and invest $10,000 annually for the next 20 years. However, each of them had very different investment methods in mind:
Opportunities for Diversification
When creating an investment portfolio, it's essential to include securities whose performance does not tend to move in tandem (i.e. that are uncorrelated) with other investments. That way, if one holding falls in value, the loss may be made up with another holding that generates a positive return. Potential opportunities to diversify a portfolio include:
International Stocks: Historically, stock market performance is driven by corporate earnings. While earnings of some U.S. companies may decelerate given a moderating economy, there are stocks in non-U.S. countries that are experiencing solid growth. As such, adding an international stock component to a portfolio may add valuable diversification.
Convertible Securities: A convertible is a type of bond that can be converted into a predetermined number of shares of common stock. During periods of market volatility, convertibles may be a useful addition to a portfolio as they provide the upside potential of stocks and the downside cushion of dividend income.
Don't Go It Alone
In today's world of instant and often conflicting market news, it's all too easy to lose sight of your ultimate financial goals. This is especially true during periods of extreme short-term volatility. Rather than try to cope with the market's ups and downs on your own, we encourage you to work closely with your financial advisor. In addition to helping you maintain a diversified portfolio, he or she can provide important guidance and support so you do not make ill-advised decisions that could derail your long-term objectives.
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